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Economy in Brief

European PMIs Improve But Show Wear and Tear; If It's Not Stagflation, What Is It?
by Robert Brusca  November 2, 2021

You are seeing a lot of articles written on the impact of supply chain problems, hearing questions about inflation asking whether it is permanent or temporary and courting further questions or fielding assertions saying we are headed for a period of stagflation. These issues are related; we will tackle them head-on right here... and now.

The table below establishes some important facts about the state of the European economy/economies. The EMU is both ‘an economy' and a series of separate economies. The non-EMU countries listed are of course separate economies. But the EMU and the broader EU designation are bigger than a breadbox. They encompass or impact all of Europe whether the neighboring economies are members or not (yes this means YOU, too, U.K.). Some are more independent than others and some are more captive; it's the nature of the economic beast.

Let's start with the end column of data in the table. The median reading for these 17-entries is at 84.5%. This means that with 17 countries' data pooled for a period of 4 ¾ years (57 months) the current median standing for this group in this timeline is just below the top 15% mark. Performance in the top 15% of what it has been in the last 4 ¾ years is a solid and strong performance. Only Hungary and Slovenia have readings that are below their respective individual medians on this timeline. That is only 2 out of 17 countries (a touch less than 12%).

Agreed that these are just PMI statistics and only for the manufacturing sector. But that is part of the issue. Service sector data are up-to-date only through September and the EMU service sector PMI for September is at 56.4 and has an 87-percentile rank standing. The U.K. service sector standing is 79%...and so on. The service sector PMI values tend to be lower than in manufacturing, but their percentile standings (ranking among their own historic data) are not necessarily showing they are relatively weaker. Ranking statistics by their nature are relative not absolute.

Stagflation...
To address a stagflation question, we need to ask about growth. Is it weak? Is it too weak? Is something holding the economy back from achieving normalcy? Is something redirecting stimulus to prices instead of taking up existing economic slack and augmenting output? Here, the answers are more complicated. Just remember in the basic Keynesian model bottlenecks can cause inflation, but if there is economic slack the slack should be taken up before inflation is created or the inflation effect may just be...temporary and will disappear when the impediment to resource movement is removed.

I would first look at the manufacturing PMIs and note that there is - and been - a slowing in train as from 12-months to six-months to three-months fewer entries in the table are showing period-to-period improvement. However, on the short scale (month-to-month data over three-months), there is some improvement this month but with more entries weakening that getting better.

Chain, chain, chain...
Many point to the now infamous supply chain problems. Some make the distinction that supply chain issues such as in transportation bottlenecks are not the whole problem. That is correct. And, in fact, the supply chain is the whole ball of wax. It is the foreign production and all the transportation it takes for delivery. It includes any added steps for additional fabrication until a good that has been produced lands in the U.S. at its final destination. There may be only one foreign factory involved and many different modes of transportation used. The supply chain may even be wholly domestic and cut across state lines. Anywhere production exists and is not wholly in one place horizontally and vertically integrated it is a supply chain. Some are short; some are long. So, I make no distinction whether output is overseas and lower or if supplying factories are cranking output that gets stuck on a ship at sea and not delivered. For the moment, there is no difference in these things. They are all supply chain issues and they result in product delivery being delayed.

The misdiagnosis prognosis
The global pandemic has led to policies and reactions that have degraded supply chains everywhere and eroded labor force participation as well. This is what complicates any assessment of ‘stagflation.' If fewer people are working in the supply chain - wherever it is - then trend growth eventually will be lower. That may be a shift and it will erode growth as well as growth prospects. But that is not stagflation. It might look like stagflation because growth will be slower than some think ‘it should be.' If governmental and monetary economic experts misdiagnose the problem, that error does not transform the problem into what they diagnose. Instead, reality bites and if policymakers get reality wrong, reality will bite back. Most at risk is the assessment that economies may not be back to full employment just yet. That conclusion would lead policymakers to assume that they could be more stimulative with policy. But as we can see, manufacturing sectors are doing quite well. Even services PMIs such as they are available are in pretty good shape. Have they been better? Stronger? Sure. But no metric goes to and stays at its zenith. Economies are at risk to what could be the wrong judgement: that change that is really structural change will be misidentified as a fleeting distortion that justifies too much stimulus for too long.

Looks like slack…but is it?
Anyone with the ability to walk around and look at the economy surrounding them can see that many businesses are still shuttered; some are running at a reduced scale. Clearly the global economy has done better. But thinking that it can or should or will do better with an added push – simply assuming that the needed resources to reopen business are there- is making an heroic assumption that may not be true.

Vaccine wariness could play a role...
Pandemic policies and reactions to the Covid threat have reduced workforce participation and if that stays as a reality then long-term growth is simply going to be lower. And that is simply due to an important behavioral variable: the participation rate. Some are too worried about the virus to go back to work. And with the new flaws that have been found in the vaccines, the reticence to work could endure. If it does, eventually these eco-drop-outs will have less discretionary income to spend and growth will be slower. But that is not stagflation. That is a shift in the long-term growth rate. In the U.S., the Fed is focused on not hiking rates until the economy is at full employment. If the Fed needs to hit the old low on the unemployment rate or re-employ all those who lost jobs before it raises rates, there will be trouble in the U.S. since there are now work-force drop-outs who are not going back to work. In Europe, the policy game is about the same but is less structured and explicit. So, the danger here is that the Fed could set a target for jobs/unemployment that is not achievable. The ECB could overstay its stimulus too long as well.

On the inflation, if there are idle resources economists would generally expect them to reallocate and through market forces. In this way, needs would be filled stopping inflation that arose through a misallocation effect or because of localized shortages.

The Fed: Inflation is temporary
That is a short version of the Fed's belief that inflation is temporary. But part of it now is rising oil prices. Part of it is supply chain-caused shortages. The Fed believes that once supply chain issues in the transportation sector are resolved we go back to normal with low inflation, lots of information and technology to bring price information to people and to feed competition in addition to a restart of international competition. But this is a partial story.

A fuller accounting of change
The full story is that time flows in only one direction and you can never go backward. The economy has changed from the one we had from 2015-2018 when the Fed could not (in fact did not try to) hit its inflation target. That economy is gone. Why, you may ask… the reason is severalfold. For one, the move to reduce the use of carbon is already playing out and has led to the cancellation of some petrochemical investment that will and is affecting supply. That will raise energy prices and that will make a difference for inflation until the transition to green energy is made...if that ever happens. Next, the is the fact that pre-Covid we had lived in an era of price and cost minimization. Consumers hunted the internet, used their cell phones to find the lowest prices. Third, firms pushed back against price increase afraid to raise their own final product price lest they lose customers. Then Poof! We have Covid. And suddenly things are in short supply and prices are rising and no one is pushing back. This is the next things that has changed. No push back and no more fear of raising prices. In the era of price and cost minimization, prices and wages were rarely raised. Since prices could not rise, wages would not rise. But now wages are going up. And there is also a movement to pay people better on top of that as a political issue. It is far from clear to me that we are going back to the era of cost minimization or even that we can go back. In fact, supply chain dynamics suggest that we will not go back. Firms are pulling up stakes from lowest cost localities to find slightly more reliable places to produce. Risk management decisions are trumping cost minimization decisions. So the entire cost structure of the supply chain is changing and changing in a way that will be more permanent and more inflationary. In the era of cost minimization, there was no wage price spiral because neither wages nor prices moved, let alone spiraled! But now both wages and prices are in gear. It may be much harder to stop this once the dynamic gets going.

Remember life itself is temporary...
So the Fed calls this temporary. Well, the inflation of the 1970s was temporary; it got worse in the 1980s! Then the 1980s inflation was temporary and it segued into what we had before covid struck- but that took a long time. In that sense, no state is permanent in economics. But various states can last long enough to be either a policy success or a disaster. I do not think this is going to be a policy success. So, call inflation temporary if you want but don't ignore it. If you stand in a pedestrian walkway and car is coming toward you, you don't worry about whether the car's momentum is temporary. Of course, it is. But that is not the question on your mind. You worry whether the car's momentum will stop before or after it runs you over. You see temporary is simply the wrong issue.

Summing up
To me there are aspects of both inflation and economic growth that stem from the arrival of Covid. But Covid did not cause inflation or slow growth. It was the government policies that were adopted that did that. And then Covid prompted some changes in behavior. Among those is a lower worker participation rate. Government policy bankrupted and eliminated some businesses- not Covid. I do not see inflation arising from the slower post-Covid growth or vice versa. I see a dynamic related to changes in behavior – not due to any market imperfection. The supply chain changes will be sorted out and some of the shortage-caused inflation will be addressed by that. But there will also be new and higher costs from the new market structure. It is a new world we are headed for all sorts of new dynamics with more people working from home, fewer people working at all and more business done over the internet for better or worse. A lot of that will be for the worse. Beware of scams, and lower worker productivity. It will be more difficult for firms to train new workers who will not learn as easily from colleagues quite as well by being at home. But none of this is stagflation.

Commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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