RaboResearch - Economic Research

Dutch Economy Nears Tipping Point: High Inflation Causes Contraction

Economic Quarterly Report

  • The Dutch economy is nearing a tipping point: after strong growth rates in early 2022, high inflation is expected to cause economic contraction at the end of this year and early next year
  • Inflation (HICP) is projected to be 11.4% this year and 4.9% next year
  • We expect economic growth of 0.2% in 2023 (after 4.7% in 2022)
  • Underlying it, however, the economy shrinks for two quarters in a row; around it, it barely grows
  • The main reason for the weak economic development is the contraction of household consumption; purchasing power is severely affected by high inflation
  • Lower investment and a weak export picture also contribute to growth stagnation
  • The yet-to-be-presented 16bn support package compensates households for loss of purchasing power; the government does not, and cannot, compensate everyone

Overall picture

The Dutch economy is expected to grow at a relatively high 4.7% this year. Next year's growth rate is expected to be only 0.2% (see Table 1). We see a contraction in the last quarter of this year and the first quarter of next year and small growth rates in the remaining quarters. Skyrocketing inflation is the main reason for the expected weak economic period.

This high inflation ultimately affects almost all GDP components and the labor market. Because the economic damage of inflation gradually trickles down into the economy, we do not expect a large short-term negative shock, but rather a longer-lasting growth stagnation. Because high energy prices are so dominant in this estimate, the differences between energy-extensive and energy-intensive sectors are large.

Government consumption and investment in particular are propping up economic growth. They are the only two items where we expect positive growth. This is mainly due to the ambitious plans from the coalition agreement. But we do not expect all of these to be achievable due to the scarcity of personnel and (expensive) materials.

The growth stagnation also has consequences for the labor market. The already initiated rise in unemployment continues, bringing it to an average of 4.1% of the labor force in 2023. This is still well below the long-term average (6.1% since 2003), indicating continued tightness. 

Table 1: Economic expectations for the Netherlands
Table 1. Economic expectations for the NetherlandsSource: Statistics Netherlands (CBS), RaboResearch

Current situation is thriving

The Dutch economy is approaching a tipping point. Recent history paints a rosy picture across the board. In the second quarter of this year, the economy grew by no less than 2.6% compared to the previous quarter. Many Dutch people started spending their money again when all the corona-related restrictions expired. At the same time, companies invested considerably more and exports grew remarkably fast. All spending components of GDP are again (well) above pre-corona levels (see Figure 1). Household consumption still appears to have room for further recovery, but the rest of the economy was running at full speed.

This is well reflected in the labor market. This was again particularly tight in the second quarter. The number of vacancies is still much higher than the number of unemployed, and although unemployment has been rising slightly since April, it is still at a historically low level.

Figure 1: All GDP components back above pre-corona levels in second quarter
Figure 1. All GDP components back above pre-corona levels in second quarter Source: Statistics Netherlands (CBS), RaboResearch

The Netherlands stands out positively

The high growth in exports is notable because the economies of several of the Netherlands' major trading partners are not doing as well. The economies of Germany, the United States and the United Kingdom did not grow, or even contracted slightly, in the second quarter. Because a similar picture emerged in previous quarters, the Dutch economy has also grown significantly faster than the other major eurozone economies since the start of the pandemic (see Figure 2).

Figure 2: Dutch economy grew significantly faster than that of other euro countries
Figure 2. Dutch economy grew significantly faster than that of other euro countriesSource: National Statistical Offices, Macrobond

Inflation is big culprit

So much for the good news. Inflation has been rising hard since the beginning of this year and the end does not seem to be in sight. In August, the general price level was 13.6% higher than in August 2021. We expect inflation to rise a bit more in the coming months, before gradually falling. Nevertheless, it will still reach an average of 4.9% next year, after an expected sky-high average inflation rate of 11.4% for this year. This is mainly because some of the products and services are rising in price with a lag. This is because higher raw material and energy costs are not always immediately passed on in higher sales prices. In our estimate, we do not expect any physical gas shortages next winter, but we do expect the price of gas to remain high for a long period of time.

Uncertainty remains high

Our estimate is subject to considerable uncertainty. We have not seen high inflation for a long time, and its macroeconomic impact is difficult to estimate. It is clear that many households will have to adjust their spending patterns or may run into financial difficulties, but it is uncertain to what extent this will ultimately affect economic growth. The fact that we have not seen much of it in economic statistics so far is encouraging on the one hand, but it could also mean that the difficulties are simply yet to come.

We also do not know how long inflation will remain at this level. Energy prices are high and extremely volatile. How long they remain high, and how high, depends very much on Russian and European policy decisions. These are almost by definition unpredictable. The uncertainty is particularly true when contingency plans possibly come into effect in the winter, causing individual companies or entire sectors to (partially) shut down.

On the other hand, the economic damage may not be as bad as expected. Households can, for example, use their extra savings from the corona crisis to compensate for the loss of purchasing power, although this is obviously not a permanent solution. If we have a mild winter, gas stocks will be depleted more slowly. As a result, it is more likely that energy prices will not rise further. They may even fall somewhat.

Investments are under pressure

Business investment generally reacts strongly to cyclical developments. The current situation is no exception. Uncertainty about future economic activity and declining profitability are putting a brake on business investment. The confidence indicator for manufacturing is already indicating declining growth (see Figure 3). Fewer and fewer companies expect production growth in the next three months. In addition, central banks around the world are gradually, but at a decent pace, raising their policy interest rates. This is seeping into companies' borrowing costs, hampering investment growth. All in all, we expect a sharp contraction in business investment in 2023. This is partly due to incidentally higher investments in the second quarter of 2022, mainly in ships and aircraft. These increase growth in 2022, but reduce it in 2023.

Residential investment is expected to contract slightly in 2023, after growing briskly this year and last year. Here, inflation does not play the main role, but materials and staff shortages are causing less to be built than desired. Also, the number of building permits issued in the second quarter decreased by 27% compared to a year earlier. The increase in new construction, as desired by the government, is therefore not yet reflected in the figures for this year and next.

Figure 3: Confidence within industry declines
Figure 3. Confidence within industry declinesSource: Eurostat, Macrobond

Exports not immune to high inflation

Exports will be under pressure in the coming quarters, as economic growth is also expected to slump or even turn into contraction for our major trading partners (see Figure 4). This affects the demand for our goods and services. Here, too, an abrupt big shock is unlikely, but we foresee a somewhat longer-term stagnation of growth and limited contraction. The strong performance of the Dutch export sector in recent quarters shows that, in principle, it is in good shape, but we do not expect this development to continue.

Figure 4: Key export countries of the Netherlands barely growing or expected to shrink in 2023
Figure 4. Key export countries of the Netherlands barely growing or expected to shrink in 2023Source: National Statistical Offices, Macrobond, RaboResearch

Purchasing power decline makes itself firmly felt

High inflation has the most direct - and therefore the greatest - impact on household purchasing power. Without strong government intervention, it is inevitable that private consumption will suffer. We therefore foresee a contraction of private consumption on an annual basis of almost 1% in 2023. Again, the contraction is concentrated in the last quarter of this year and the first quarter of next year. Consumption barely recovers thereafter, as the overall price level is expected to remain high, and wages only partially rise with the higher price level. The government is trying to compensate for part of the loss in purchasing power, but cannot prevent the purchasing power from declining substantially for many households on average.

Historically hard drop in real income

The development of real income (i.e. the increase in income corrected for inflation) largely determines the development of purchasing power. Income consists mainly of wages, benefits (including pensions) and income from privately-owned businesses and assets. This year, average wage growth is lagging far behind inflation, resulting in a real wage drop of more than 8% (see Figure 5). Next year it will be virtually zero, as both wage growth and inflation are expected to be around 5%. Benefit income develops, with some delay, in line with the average wage, so in real terms it also declines sharply. In the case of second-pillar pensions, the positive effect of the higher interest rate on the funding ratios more than outweighs the probably lower investment return than in previous years. Indexation is therefore very likely, but it is unclear to what extent this will be possible.

Figure 5: Very sharp decline in real wages in 2022
Figure 5. Very sharp decline in real wages in 2022Source: CPB Netherlands Bureau for Economic Policy Analysis, RaboResearch

The government intervenes

However, the expected change in real gross income does not yet tell us how purchasing power will develop. This is because it also depends heavily on government policy. For the current year, the government has taken various measures to improve purchasing power. Some of the measures (excise tax reduction on fuels, energy tax reduction and the VAT rate on energy) have slightly reduced inflation this year. Without these measures, inflation would have been 16.6% in August instead of the 13.7% it ultimately was. The government also introduced an energy surcharge of EUR 1,300 for low-income households. All in all, according to the CPB, the median change in purchasing power is -6.8%, a contraction unprecedented in a historical perspective (see Figure 6). For low-income households, the decline is smaller because of the energy surcharge.

Figure 6: Unprecedented drop in purchasing power in 2022
Figure 6. Unprecedented drop in purchasing power in 2022Source: Statistics Netherlands (CBS) (1978-2002, 2012-2020), CPB Netherlands Bureau for Economic Policy Analysis (2003-2011, 2021-2022), RaboResearch

For 2023, the CPB predicts a purchasing power increase of 0.6%, but this does not include the purchasing power package that the cabinet will announce on Budget Day. What the package looks like exactly is still unknown, but many measures have already been leaked. It looks like the measures for 2022 will be continued. These are - except for the energy allowance - all generic measures in which money largely ends up in households with above-average incomes. As such, they are untargeted; the government would have been better off replacing them with measures that target financially vulnerable groups.

The cabinet will also present several new measures on Budget Day. A higher minimum wage (including the link to the height of several benefits) and a higher healthcare and rent allowance are very specifically targeted at low-income households and therefore effective in this situation. The fact that the state pension will also go up is much less targeted. Poverty among the elderly is relatively low, so that specific support for the elderly with no or a small supplementary pension would have been more effective. Although households with above-average incomes also benefit from a higher child budget and a higher labor tax credit, the largest part does reach the financially vulnerable group. The reduction in rate of the first bracket of income taxes is unfocused, because everyone with an income benefits from it and because low-income earners normally already pay (almost) no income tax.

The government is seeking (partial) cover for the support measures from the business community and the wealthy. The exact design will determine whether the measures are wise, but they almost certainly work towards a structural improvement of the tax system.

Below the line, household consumption declines

Presumably, the 2023 purchasing power package mitigates the purchasing power decline for many people. It is better targeted at financially vulnerable households than the 2022 package of measures, although it could have been even better. Whether it is sufficient cannot be determined on the basis of the available information. What is clear is that the government cannot fully compensate everyone. The Netherlands is becoming collectively poorer as a result of more expensive imported energy. We therefore expect that declining household consumption will contribute hugely to the predicted economic contraction.

But even if it had been financially possible to compensate everyone, it would have been partly counterproductive. Stimulating the production side of the economy is difficult, given the shortages on the labor market and on the international markets for raw materials, semi-finished and finished products. Too great a boost from the government will therefore almost certainly cause even higher inflation, which in turn will further erode the purchasing power of households. The plan to raise taxes elsewhere fits in well with the effort to keep the size of the overall stimulus as limited as possible.

Frank van Es
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO

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