An interest rate rise to curb inflation that will stick in Spanish throats

Spanish leaders came out in droves to boast about employment figures, despite these being the worst in Europe, and this against a backdrop of plummeting business confidence and mixed data from the US – good employment figures but dismal GDP and inflation figures– which point to another interest rate rise in September, which, much to their chagrin I imagine, but above all to the chagrin of the Spanish people, the ECB will have to follow suit. This is going to be a bitter pill for us Spaniards to swallow, given that we are one of the few developed economies that have not even recovered to pre-pandemic levels. And this is in a scenario where our leaders have decided that the solution is to spend more, rather than to invest. But where is the money going to come from? Perhaps it will be up to the European Commission to somehow solve this puzzle.

By Miguel Ángel Temprano

29 July 2022 Reading time: 3.40 mins

Yesterday, a series of macroeconomic figures were published in both the US and Europe, demonstrating the complexity of the current economic situation; taken together, these figures can only be interpreted to mean that we are heading into a recession, the end of which can only begin once the Russian army lays down its arms in its unjustified invof Ukraine.

But we Spaniards – although it seems we favour moderation, we actually swing from one extreme to the other in everything – are set to suffer a deeper and more painful crisis than others, mainly because this time, unlike on previous occasions, we have not even recovered our pre-pandemic economic levels.

“We Spaniards like moderation, but I don’t know why we swing from one extreme to the other”

Yesterday, the EPA told us that employment is recovering, but that we are still seeing unemployment figures that are unbelievable for a developed economy.

Although those in power turned out en masse to celebrate these figures, these figures show that our society, which continues to have one of the lowest labour force participation rates in the region, has an unemployment rate four times higher than that of Germany, double that of our neighbours, the Portuguese or the French, and even higher than that of the ‘pariah’ Greece, which has been bailed out.

The truth is that, given these figures, I don’t know what they’re boasting about, but the fact that they do so highlights the lack of maturity in our society, because those in power – now and always – may be ignorant, but they are not fools, and everything they do is always based on a reason.

“We constantly read information out of context, forgetting that it can only be understood within a context”

But amidst all the media hype, one extremely important piece of data went unnoticed: the Spanish business confidence index, which plummeted into negative territory. For those unfamiliar with it, I should explain that this index is the result of a survey carried out by the INE which measures business confidence regarding what is likely to happen in the coming months, and which has been shown to correlate with business investment and, consequently, with employment. Well, it was previously in positive territory, albeit only just, but it is now well into negative territory.

At the same time, the US released its GDP growth figures, which confirmed what we had all already suspected: that the world’s largest economy had entered a technical recession, having contracted for six months.

This figure – bad, very bad indeed – was accompanied by another, which was acceptable or even good: claims for unemployment benefit in the US remained stable, which could be interpreted as a sign that the US labour market was holding up.

“In today’s globalised economy, there are no economic islands, and this is even more true between Europe and the US, where our economies are closely linked”

Many will think, ‘What’s in it for me?’ Well, it is of vital and negative importance to us Europeans, but particularly damaging for the countries of southern Europe, including Spain.

The Fed – for those who may not realise, this is the name of the US central bank, as opposed to the European Central Bank – has three objectives: the first is to use monetary policy to maintain maximum employment; the second is to keep inflation at reasonable levels to ensure the economy develops properly – the consensus is that this stands at 2 per cent – and the third is to maintain reasonable benchmark interest rates.

“We often forget that the primary mandate of central banks is not monetary policy but to work towards achieving full employment”

Well, yesterday’s figures suggest that employment is holding up, but inflation is not falling – yesterday’s preliminary figure stood at 7.1 per cent – despite the most aggressive policy of scaling back monetary stimulus since 1970, when the then Fed Chairman Paul Volcker faced the first oil crisis, which, just like now, sent inflation spiralling.

Let us bear in mind that the Fed has set a target of 1.9 per cent inflation by the end of 2023

So, it seems clear that the Americans are going to continue with their policy of tapering, which means they will raise interest rates again in September. Perhaps not by 75 basis points as last time, but certainly by at least 50 basis points, taking the base rate to 3 per cent. And this really does matter to us.

The reasons behind the current inflation crisis have several clear causes: firstly, the war, which has driven up energy prices; secondly, the disruption to the supply chain caused by the Chinese lockdowns resulting from the strange public health policy they are implementing to combat COVID; and thirdly – although its impact is becoming increasingly minor – the shortage of microchips stemming from tensions in the Taiwan Strait.

“Energy has always been the primary driver of inflation, but at critical times like this, its importance really comes to the fore”

Well then, first and foremost at this moment in time, the energy crisis has a secondary impact for Europeans. On top of the lack of sufficient oil supply, which is driving up the price per barrel, we must also consider that oil is paid for in US dollars, which – due to the Federal Reserve’s monetary policy of raising interest rates and withdrawing money from circulation – is only getting stronger, and is currently almost at parity with the euro. You don’t need to be a mathematician to realise that if our currency weakens against the one we use to pay for a good, that good will become more expensive for us – a factor that compounds the price rise caused by insufficient supply of the product itself, in this case a barrel of oil.

The inflationary impact of energy prices is proving devastating, and the ECB has very few tools at its disposal to combat it. But it does have one – and we are no longer sure whether it is a good or a bad thing for it to use it – which is to follow the Fed’s policy of raising interest rates. It’s like when the leader in an F1 race copies the strategy of the runner-up because, that way, if nothing goes wrong, they’ll maintain the gap. Well, it’s the same here: if they raise rates, so will I, and that way their currency won’t strengthen against mine and I won’t have to pay more for the goods I buy in dollars.

“The ECB is tackling inflation as best it can, and its aim now is not to cool down an economy that is not overheating, but to strengthen the euro”

Well, until a few days ago, the ECB hadn’t done this, and the dollar had strengthened by more than 10 per cent over the year, reaching parity.

Well, the bad news is that the positive US employment figures, combined with the poor inflation figures and despite the GDP figures, point to a further interest rate rise in September and the corresponding and necessary response from the ECB, which will immediately be passed on to mortgage and loan interest rates, primarily for businesses, thereby deepening the economic hole into which we are sinking.

And this is going to affect employment – which is already showing signs of slowing down – and in what way? Well, everything’s going our way.

The US is officially in recession; Germany and Italy are certain to enter one in the second half of this year, and Spain and France in the first half of 2023. This is easy to predict, but it is even easier to assert that if suspicions of permanent cuts to Russian gas supplies to Germany this winter are confirmed, these will in turn trigger a deeper recession in Germany and bring forward the onset of recession in Spain and France. And this is despite the fact that Spain has not even yet recovered to pre-pandemic economic levels and, however much those in power would have us believe otherwise, is facing rampant and unsustainable unemployment.

Economic theory and common sense suggest that when things are going well, the coffers are filled – through tax revenue – so that the money can be spent – appropriately – when things go wrong. In economics, these are known as ‘counter-cyclical measures’, designed to smooth out the fluctuations of economic cycles and make the downturns less severe.

Well, someone hasn’t explained this properly to our leaders, and after spending as if there were no tomorrow and running up the country’s debt to 118 per cent of GDP, they’ve decided to carry on spending – but on things we don’t have.

“Sooner or later we’re going to need our European partners, and we’ll see what conditions they set”

Nor has anyone apparently explained to them that a counter-cyclical measure does not involve increasing current expenditure, but rather investing – firstly because investment is what the Americans call ‘a one-off’, meaning it is done just once, and secondly because it leaves behind something that will generate wealth or help to generate it in the future.

Recurrent expenditure is usually exactly the opposite: you commit to continuing to pay in the future and leave nothing that can be used to generate further resources.

Well, they have decided to increase public spending – which is already sky-high – by 50,000 million; this money should come from taxes, but the recession will prevent it from being raised as economic activity declines, so it will have to come from more public debt, which will become more expensive for the reasons explained above.

And the question is: will our European partners allow us to do so?

To say that this is the perfect storm is uncertain, as storms are caused by uncontrollable factors, whereas in this case it is human decisions that are causing them.