In the euro area by contrast, while the nominal paycheck is growing at a healthy rate of 4%—the strongest pace since the Global Financial Crisis—real paycheck growth is stagnant or even slightly down. As a result, rising prices erode consumers’ purchasing power. And that doesn’t yet account for the 60% increase in natural gas prices in recent weeks or prospective increases in prices of soft commodities and food.
If European inflation rises further, we believe the region risks a negative demand shock this year. The European Central Bank is treading dangerously by signalling recently that it may raise interest rates, because real incomes are precarious. In 2011, the ECB bucked policy norms by raising rates when real incomes were negative, but quickly realized its error and reversed course.
In the UK, the story is somewhat similar because real incomes are negative. However, unlike the ECB, the Bank of England has already started a rate hike cycle. Raising rates might not be a great idea right now, but if the BoE continues, we think it is likely to stop sooner than it otherwise would, given the economic shock.
Dynamics in the US are different. While US inflation is higher than in Europe, incomes are also healthier. The nominal paycheck is growing rapidly at about 10% year over year and the real paycheck is growing at 2.7%, in line with its long-term average. This might not reflect every household, but in aggregate the economy is keeping pace with inflation and a little bit more. From the Federal Reserve’s perspective, this means the US economy can handle rate increases. Since higher inflation is unlikely to prompt a dramatic slowdown, we don’t think the pressures emanating from the Russia-Ukraine conflict should dissuade the Fed from raising rates.
That said, caution is warranted. Potential unpredictable outcomes could affect consumer expectations or weaken corporate investment. Some banks may have hidden exposures to the region. Given uncertainties created by the Russian invasion, we think the Fed is likely to be cautious, starting its tightening cycle with a 25 b.p. increase later this month.
In emerging markets, some central banks are in a particularly difficult position. Across Latin America and Eastern Europe, inflation pressures have been more acute and typically policymakers have already increased interest rates.
Investors never like uncertainty and tend to prefer a narrow range of outcomes. We don’t have that luxury today. But amid the gloom of war, remember that not all possible macroeconomic outcomes end in recession. For example, if the conflict ends in the near-term, commodity prices could move lower before demand destruction sets in. Policymakers around the world will need to engage in a delicate balancing act while on a fast-moving train, given the fluidity of the situation.
