Analysis – Prepare for more pain.
The first Tuesday of the month has been a regular source of anguish for many Australians and tomorrow promises more of the same.
But relief may well be in sight. The pace of interest rate hikes already has slowed and, with no Reserve Bank meeting in January, we may be approaching a period where Philip Lowe and his compadres can afford to sit back and survey the damage
Much of the rest of the developed world is following suit. The big kahuna of America’s central bank, Jerome Powell, last week said out loud that the pace of hikes would be slowing, maybe even as early as this month, sending Wall Street to the moon.
Only New Zealand seems to be hell bent on deliberately driving its economy into recession at breakneck speed. Everyone else suddenly seems to be easing back on the brakes.
As we approach the pointy end of 2022, it is becoming clear that it has been a year of monumental change, an epochal shift in the global economy.
After almost half a century of declining inflation and interest rates, the world suddenly has shifted gears, heading back to where we once were.
The past half century was a period that ushered in tremendous growth, global co-operation and trade. What accompanied it was a huge lift in debt and a spike in inequality.
At the beginning of the year, most were convinced the inflationary spike would be short term, a temporary reaction to pandemic lockdowns and war. As we approach 2023, it is looking more like something far more persistent.
Here are five factors that will likely shape our future.
1. Interest rates
The price of money. The cost of capital. Call it what you will but it is the primal force that shapes our world.
In the space of just seven months, we’ve reverted to interest rates not seen for the best part of a decade.
The breakneck pace may slow next year. But if inflation becomes more entrenched, as is likely for the reasons below, a gradual lift in interest rates over the next few years is unavoidable.
Usually portrayed as a cause for alarm, higher interest rates aren’t necessarily an evil. But adjusting to the bold new world won’t be easy, particularly for a world awash with debt.
The ever-decreasing and ultimately ultra-low interest rates of the past 50 years distorted investment decisions, created asset price bubbles and encouraged a huge lift in government, corporate and household debt across the developed world.
Along with financial deregulation, it turbocharged growth and helped shift the balance of earnings away from wage and salary earners to investors. Profit growth easily outstripped wages. When the inflation tsunami swept the globe this time last year, developed-nation workers demanded a rebalance as skyrocketing prices stripped them of earnings.
Savers, too, were penalised. With little or no return on safe investments, they were forced to take ever more risks to make ends meet, a strategy that has cost them dearly as financial markets have tanked.
The path to historically normal interest rate settings won’t be linear. If we hit a global recession next year, as many expect, interest rates are likely to steady and possibly even drop. But that may be only temporary.
Is there anything more emblematic of the current state of global upheaval and uncertainty than China?
The Communist Party-controlled economy saved Western capitalism during the global financial crisis, but the Middle Kingdom this year has morphed back to an old-style empire with a permanent leader in control of a one-party state.
Its economy has been ravaged by years of Covid lockdowns, the property bubble that helped power its growth is deflating, its population is rapidly ageing, and social unrest has begun to rear its head.
Nowhere will the long-term repercussions be greater than in Australia.
But China’s impact on global growth, and particularly inflation, will be even more profound. While its phenomenal growth since the 1980s made it a dominant force in global trade, China’s greatest export to the world wasn’t its clothing, its electronics or its heavy machinery and industry.
Its biggest export by far was lower inflation. As it became the world’s factory, its sheer size allowed it to produce ever-cheaper goods for the world.
So, while we in the West congratulated ourselves for impeccable economic management and taming inflation through brilliantly applied monetary policy, it was China that was doing all the heavy lifting for us.
That’s now run its course. And that means the continued downward pressure on prices will slow. It will remain a major economic power but unless another country like India undergoes the same kind of transformation as China, the inflation dragon is likely to re-emerge.
3. (The end of) Globalisation
Donald Trump may have been its most vocal opponent but the unrest running through developed nations had been evident for years.
As industries shut down en masse across the developed world and decamped to China, unemployment, lower real wages fed social discontent and a political shift towards the extremes, both left and right.
Generations of young economists had been taught the benefits of free trade and, in the ear of government, dismantled trade barriers in the quest for greater international wealth. On paper, we appeared to be far better off. Goods certainly were cheaper.
The downsides, however, were largely overlooked or ignored. And as the benefits accrued to an ever-smaller and wealthier group at the top and multinational firms dominated, the attraction of a globalised economy began to sour.
The pandemic put the concept to the sword as trade disruptions resulted in massive shortages of raw materials and goods. Then Vladimir Putin invaded Ukraine, shattering the illusion of a world united by commerce.
Globalisation has turned to de-globalisation.
Looking inwards comes at a cost. Having goods and services produced by people who aren’t being paid slave wages means consumers will have to pay more. That means higher prices which keeps the pressure on to maintain higher interest rates.
From a global perspective, the end result is that we are unlikely to ever again witness the kind of economic miracle we saw in China where billions of people were catapulted out of poverty within a single generation.
For nations like ours, the upside is that a greater reliance on homegrown goods and services will create more opportunities for our youth and lower unemployment.
Yin and yang.
Economics, so often esoteric and academic, usually is a battleground between various schools of thought. But a shift in economic thinking has huge ramifications for us all.
Back in the 1970s, what was known as Keynesianism died as inflation ran rampart across the world. In the post-war era, governments controlled the economy through spending, taxation and income redistribution policies.
That was replaced by monetarism, a system where central banks controlled the economy through interest rates and governments largely absented themselves from economic management.
The spark for that change came from an energy crisis after oil-producing countries, led by Saudi Arabia and other Middle Eastern producers, formed a cartel and jacked up prices, sending inflation into orbit.
Once again, we have an energy crisis that has fed into an inflationary breakout. And it has just happened to coincide with the end of monetarism or at least a point where the limits of monetary policy have been reached.
Governments, particularly in Europe, have begun to take a leading role in economic management. They’ve intervened in energy markets, hitting producers with higher taxes and distributing the proceeds among consumers. Even the UK’s Conservative government has taken the plunge, a move Margaret Thatcher would have deplored.
In Australia, similar moves are afoot. For a nation swimming in vast pools of fossil fuels, we have found ourselves facing shortages and extreme price rises as multinational companies reap mega profits from the political and economic fallout of Russia’s war on Ukraine.
A shift started by the Australian Coalition six years ago, the crisis now is likely to result in price caps and a direct intervention in what was supposed to be a “free market”. Except, it was never free. With just a handful of producers and millions of domestic consumers, it is the antithesis of a free market.
The lesson? Governments of all persuasions will be more likely to intervene in the economy than previously.
5. Energy transition
Adapting to climate change was one of the greatest challenges facing humanity long before this unexpected shift in the global economy.
It now has been given even greater urgency. Western Europe has found itself hostage to Russia’s energy warfare.
While its battlefield performance has been nothing short of an embarrassment, Russia, however, has managed to wreak economic havoc on NATO nations, the impact of which has spilled across the globe.
Germany, in particular, relies heavily on Russian gas for much of its manufacturing, and the huge price spikes have hit its economy hard. A recession largely is expected in coming months but resilience in consumer spending may limit the damage.
It’s not just gas. Coal prices have soared to record levels, which have fed into big spikes in electricity prices.
That creates opportunities and challenges. Those higher prices are likely to accelerate the push for cleaner fuels. A race is underway now between those like Andrew Forrest who believe green hydrogen will power the future and others who believe solar- and wind-generated electrification will dominate.
Until a few years ago, it was thought gas would be the transition fuel as we switched from coal to renewables. Soaring gas prices have thrown a spanner into that plan.
The cost of restructuring Australia’s energy supply is huge. For a start, there is the need to upgrade electricity grids. Right now, they are designed to transport energy from coal-fired plants around the country. As those plants shut and energy generation becomes geographically more widespread, the grid will need to be rebuilt.
Electricity, here and elsewhere, will be more expensive as a result. Ultimately, it will be cheaper than if we had done nothing and continued with fossil fuels. But it is likely to cost more than it does now.
That will further fuel inflation. And that means higher interest rates.
Welcome to the 1970s.