Desperate times call for desperate economic measures

8 Sep 2022

Governments resort to historic economic measures that may have unintended effects down the line — and increase the role of the government in advanced economies. Panicking about energy costs has upped the ante.

Governments around the world are increasingly having to resort to desperate measures to withstand the multi-pronged headwinds facing the global economy — and these historic decisions are likely to have long-term consequences after the dust has settled.

This week, both the UK and Europe put in place energy packages that include capping prices to contain the devastating impact sky-high gas prices would otherwise have on the regions during the upcoming winter.

Gazprom’s much-anticipated decision to shut down Europe’s access to Nord Stream gas supplies upped the ante on the eurozone’s already dire energy crisis. The news sent the benchmark Dutch gas prices up a third, to €281 per megawatt hour.

As the various moving parts have shifted in response to Russia’s weaponisation of energy supplies, the European Commission has been adjusting its energy package to reflect the new realities. Initially, it comprised a combination of different measures, from encouraging people to use less gas to gas rationing, should the going get really rough.

Windfall tax

Now the Commission is considering imposing a levy (a windfall tax) on excess profits made by energy providers, including companies producing renewable energy, with their prices skyrocketing in line with the price of gas. It is also looking at putting gas price caps in place.

Politico’s Jakob Hanke Vela has seen the document that is a work in progress and says: “Experts at the European Commission, in national capitals and in embassies have been working around the clock over the weekend to speed up plans for an emergency intervention to protect households and companies — with many leaders warning of massive social unrest if prices are not brought under control.

“The final legislation is expected to be made public when European Commission President Ursula von der Leyen delivers her annual State of the European Union on 14 September.

With Liz Truss formally sworn in as Britain’s new prime minister this week, the UK is also likely to see far-reaching measures to alleviate the impact of high gas prices on households.

UBS Global Wealth Management chief economist Paul Donovan says the suggestion is that the current price mechanism would be replaced by a price set by the government.

“This implies a price cap, which should lower the peak of UK inflation. It might be too late to save the consumer, who, according to BRC retail sales data, has curbed consumption in the wake of terrifying tabloid headlines.”

In addition to tackling the energy price crisis, Truss is set to introduce a host of other economic policy shifts that will inevitably beef up the government’s participation in the economy and reduce taxes — leaving economists guessing about whether these will be fiscally possible.

Jumbo rate hikes

Against the backdrop of emergency energy plans, central banks continue to implement jumbo rate hikes of 75 basis points, and, significantly, the US financial markets are no longer pricing in US rate reductions in early 2023.

The battle to contain inflation is likely to rage on for some time, it seems.

This week, the Bank of Canada hiked interest rates by 75 basis points (bp) after its surprise 100 bp hike at its previous meeting — the biggest rate hike implemented to date by an advanced economy during the current interest rate cycle.

The move is based on the central bank’s view that inflation remains too high and, despite the decline in gasoline prices, core inflation is still rising and price pressures are broadening.

Oxford Economics warns that Canada is a highly interest rate-sensitive economy and, “along with a deteriorating external environment, makes a recession the most likely outcome for the economy”.

The European Central Bank followed on with an also unusually high 75 bp rate rise — its highest since the start of the monetary union, according to ING Global Head of Macro, Carsten Brzeski, who responded to the news by saying: “The ECB did it. In a historic move and the single largest rate hike since the start of the monetary union, the ECB just announced it will hike all three policy interest rates by 75 bp.

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“We still can’t see how monetary policy can bring down inflation that is mainly driven by (external) supply-side factors. Even the impact of policy rate hikes on inflation expectations is anything but certain.”

Donovan also warns that, as with the Fed, rate increases “will not touch the European energy crisis” and questions whether such an increase could create deflation in other areas of the economy.

On the other side of the equation, China recently surprised with a move that also reeks of desperation when it reduced interest rates last week to stall the sharp decline in its economic growth momentum and provide some relief in the property sector.

Though the People’s Bank of China does have the policy room to relax monetary policy and increase fiscal support, this could prove exceptionally costly if economic conditions continue to worsen as a result of its zero-Covid policy, which events over the past week show that government is set on, seemingly at all costs.

Not even a 6.8 magnitude earthquake in the Sichuan province could deter the government’s insistence that, in a province of 84 million, people should continue to stay at home.

Growth headwinds

The common denominator between all these countries is that they are facing intensifying growth headwinds, with consumers and businesses getting more and more worried about what the future holds for them. Capping gas prices in the UK and Europe would go some way to easing their concerns, but could have long-term consequences.

Introducing artificial pricing measures inevitably messes with market-driven forces that ultimately bring demand and supply forces into balance over the medium- to long-term. Short-term issues are that if the price of a commodity is subsidised, it doesn’t encourage the right behaviour — namely, using less gas when prices are painfully high. DM/BM

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Windfall tax

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