Friday 20 May 2022

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Decoding - In the euro zone, the acceleration of inflation is becoming widespread

The Eurozone has been facing a sharp acceleration in inflation since the spring of 2021. This was first deemed to be "transitory" but the movement turned out to be much stronger in magnitude and duration than expected, in large part because the energy crisis persists. It is increasingly clear that the acceleration in prices is becoming widespread. This spectacular reversal, after a decade of too low inflation, means that the ECB is considering becoming a “normal” central bank again.

The acceleration of European inflation was a real surprise

Europe has been facing a sharp acceleration in inflation since the spring of 2021. This was first deemed to be "transitory" and due to the conjunction of several factors: base effects linked to the covid crisis and temporary cuts in VAT, the reopening of the economy with sharp increases in prices in the energy and services sectors where demand picked up after a sluggish 2020. However, the movement turned out to be much stronger in scale and duration than anticipated. The magnitude and speed of revisions to inflation forecasts for 2022 is thus unprecedented. The war in Ukraine and the intensification of supply chain disruptions with lockdowns in China are currently playing an amplifying role in an already clearly established trend.

In the end, headline inflation reached 7.4% in April 2022 and inflation excluding food and energy 3.5%. Inflation is even above 10% in 5 euro zone countries. The ECB's inflation forecasts have been revised very sharply upwards. This contrasts with the 2010 decade (average inflation of 1.35%), when excessively low inflation pushed the ECB to adopt ultra-accommodative measures.

Initially, an energy crisis… which lasts

Europe, a big importer of natural gas, suffered a sharp drop in Russian gas deliveries from the summer of 2021. At the same time, the decrease in electricity production from coal-fired power stations (closures), wind (less wind) and nuclear (reactors shut down) sources shifted energy demand to natural gas and increased prices. The rules for setting electricity prices in Europe take the wholesale prices on the gas markets as a reference. Soaring gas prices led to a sharp rise in electricity prices.

The war in Ukraine then amplified tensions on oil and gas prices. Households have therefore suffered from a rise in fuel prices but also in gas and electricity prices, the weights of which account respectively for 4%, 2% and 3% of the consumer price index.

If at the level of the euro zone as a whole, we observe the beginning of a slowdown in energy prices from April (+38.0% over one year in April after +44.4% in March), this does not yet show a clear trend and is not yet observable in all the countries of the zone.

A more widespread price increase than initially envisaged

As Christine Lagarde mentioned in a speech on May 11, all core inflation measures, including those that capture persistent elements, are now above 2%. The various measures of inflation expectations as well. For her part, Isabel Schnabel insists on the fact that the measures of trimmed inflation (which exclude from the consumption basket the components whose prices have increased the most and those whose prices have fallen the most) are very similar between the United States. United States and the euro zone (much more than underlying inflation). This suggests that the underlying price pressures are accelerating at a similar pace in the euro zone and the United States. In the United States, inflation is driven by a limited number of components (housing, used cars, for example), while in the euro zone, the rise now appears to be more widespread. If we look at the 73 components of core inflation in the euro zone, 60 were accelerating over 3 months in April 2022.

Prices for non-energy industrial goods were up 3.8% year-on-year in April. The increases reach 7% for vehicles or 6.5% for furniture and furnishings. Economic surveys show that manufacturers are more and more inclined to pass on cost increases in their selling prices. We therefore feel here, as in the United States, that the tensions on the supply chains give rise to inflationary tensions.

On the services side, the rise in prices stood at 3.3% over one year in April, driven by cafés-restaurants (+4.6% over one year in April) and accommodation (+11.3%) marking the effects of the reopening of certain parts of the economy following health measures. Here, as in the United States, we feel that the labor problems encountered by the hotel/restaurant sector during the covid crisis have had a strong impact on prices.

What outlook for inflation?

The peak of inflation is expected in autumn 2022 once the price increases on the wholesale electricity and gas markets have been passed on to the prices charged to individuals. However, the rise in inflation now seems more generalized and uncertainties hang over the evolution of food and oil prices and the wage increases that will be observed in Europe in the second half of the year. These will be important to assess whether a price-wage loop is taking place.

The war in Ukraine and the sanctions have led to both an increase in the prices of energy and other products of which Russia and Belarus are major producers such as fertilizers and agricultural raw materials, cereals or vegetable oils... Food prices are already rising at a very sustained pace, +6.4% over one year in April and even 9.2% for unprocessed food. But the rise in agricultural commodities has not finished having an impact on consumer prices. Indeed, if we take the example of France, food manufacturers are demanding new price increases from distributors while negotiations have already taken place at the beginning of the year.

Slow wage growth (for now…)

So far, wage increases as measured by the ECB's negotiated wage indicators show only moderate increases: +1.6% year-on-year in Q4 2021 for the Eurozone. Certain national measurements provided on a monthly basis show a tremor in certain countries such as Spain (+2.4% in April) and the Netherlands (+2.8% in April). A Bank of Spain study on collective bargaining establishes that in the 1st quarter of 2021, when inflation was at 0.5%, 98% of negotiated wage increases were below 2%. In the 4th quarter of 2021, the proportion of wage increases below 2% fell to 57%, which is a sign that rising inflation has started to have an impact on wage negotiations. The Bank of Spain also remains attentive to the introduction of wage indexation clauses on inflation, the proportion of which has tended to increase in recent months.

Isabel Schnabel recalls that negotiated wages are lagging indicators of labor market tensions and that it will be necessary to monitor the wage negotiations that will take place in the various countries in the second half of 2022. These could lead to more substantial increases. Thus, IG Metall, the metalworking union in Germany, is starting its collective bargaining with a demand for an 8.2% wage increase over 12 months. The union justifies its demand by saying that “even if collective bargaining alone cannot solve the problems caused by the enormous price increase, the employees need compensation for the increase in the cost of living. »

The ECB aims to become a “normal” central bank again

The generalization of the rise in prices in the eurozone that we have just described, coupled with the sharp rise in inflation expectations (whether in terms of market-based measures or surveys among companies and households) means that the ECB now plans to become a “normal” central bank again. One of the narratives at the heart of the adjustment of the ECB's communication was the fact that the euro zone has probably left the low inflation regime (“lowflation”) that it experienced during the 2010s. The (very dovish) ECB chief economist, Philip Lane thus indicated on May 5 that it was “unlikely to revert to the persistent below-target inflation trend that was so entrenched before the pandemic" and even that it was necessary to "closely monitor" a possible un-anchoring of inflation expectations. The Banque de France Governor had made similar comments on several occasions in previous weeks. Isabel Schnabel puts it this way: “as risks are growing that current high inflation is becoming entrenched in expectations, the urgency for monetary policy to take action to protect price stability has increased in recent weeks. »

Like almost every market participant, the ECB has been extremely surprised by the acceleration of inflation and it is clear that a part of it, caused by the invasion of Ukraine by Russia, was impossible to predict. But we can still note an inconsistency in the fact that the Governing Council announced in December 2021 the continuation of the APP asset purchases until at least the end of Q3 2022 (and even without a date precise end), while Christine Lagarde had indicated a few days earlier that it was better "to avoid making long-term commitments"... Let’s recall that in theory, announcing a asset purchase program is supposed to postpone the expected date of the first rate hike (“signaling effect”). In the same vein, Lagarde maintained for some time that a rate hike in 2022 was “very unlikely”. This inconsistency led the ECB to quickly backpedal on the asset purchase policy:

There is obviously a part of the Eurozone inflation that comes from supply shocks, to which the ECB can do absolutely nothing, but the levels reached are so high that the ECB finds itself in a situation where it is no longer wise to stimulate demand with key rates below what could be described as a “neutral rate”. Over the past ten years, Governing Council members have mentioned the concept of a “neutral rate” much less often than their counterparts in the FOMC, in particular because the ECB considered that the estimates were too uncertain. Nevertheless, Isabel Schnabel mentioned this point explicitly in her interview of May 3: “We are starting from an extremely low level. Real interest rates are still deeply negative and close to their historical lows. That means that even after the first increases, interest rates will remain at levels that continue supporting the economy. We are still quite far off from a neutral interest rate, that is the point as of which the economy is slowed.” The estimates (subject to high uncertainty) of the neutral rate by ECB economists generally hover around 1.5%, as can be seen during presentations by Executive Board members.

In recent days, the Governing Council members have multiplied the signals on a first rate hike as early as July, which would be the first rate hike by the ECB since April 2011. The “normalization” of monetary policy with regard to the key rates should then lead to a reflection on the size of the Eurosystem's balance sheet: indeed, the other central banks of the developed countries that have started a policy of raising key rates have announced a policy of balance sheet reduction (more or less aggressive depending on the countries). This will not be without causing difficulties for peripheral sovereign debts.

In the space of a few months, things changed radically and spectacularly as far as Eurozone inflation is concerned. The covid crisis, with the disruptions to supply chains and labor markets it caused, and then the energy crisis gave rise to fairly broad-based inflationary pressures in the eurozone. For the ECB, the era of “more dovish, for longer” seems to be over and the goal now seems to be to become a “normal” central bank again.

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By Juliette Cohen, Strategist and Bastien Drut, Chief Thematic Macro Strategist