Is Europe Facing Stagflation?

Headline inflation continues to rise, while growth momentum is slowing down. Surging energy prices could make the situation worse – in both areas. No surprise then that markets are fretting about stagflation risks, although it may be time to acknowledge that efforts to leave the pandemic behind as quickly as possible and return to “normal” is just not possible and merely exacerbating the problems.

Eurozone HICP inflation hit 3.4% y/y in the preliminary reading for September, the German rate a whopping 4.1% y/y and more increases could be underway, depending on weather developments, as energy shortages in Europe are adding to the difficult outlook. The situation is not quite as difficult as in the U.K., but even if in theory continental storage facilities are much larger than those across the channel, the reality is that most producers have been eager to fill their own storage first after the disruptions caused by the pandemic, which together with the backlog in maintenance means storage levels are lower than they could be this time of the year. The tug of war between the U.S. and Russia over new pipelines in Europe and speculation that Russia is deliberately adding to the problem in order to put pressure on Germany to sign off the new Northstream2 pipeline as early as possible is not helping of course.

Higher energy prices and even more importantly a squeeze in supply has the potential to severely curtail the outlook for growth ahead. Indeed, as a closer look at the U.K. highlights rising energy prices also have much wider ripple effects that could hit areas such as food production and storage going forward. However, while the deterioration in confidence data and today’s sharp correction in German production the acceleration in prices is fueling stagflation concerns, the numbers are to a certain extent part of the same phenomenon – namely the fact that the impact of the global pandemic has longer-lasting effects than central bankers and politicians wanted to acknowledge.

It was not just the retailing sector that was closed, part of the manufacturing sector, global shipping, the processing of containers, everything was halted or severely impeded during the pandemic and it will take time to catch up with what was lost or postponed during lockdowns. The result are severe bottlenecks in supply chains across a large variety of sectors that act as a speedbump and limit the room for expansion. German production may have dropped back -4.0% m/m in August but not for lack of capacity and/or orders. Capacity is there and production levels still clearly below those seen before virus developments hit. However, with chips in short supply globally and other intermediate good products also slow to arrive, auto-makers, in particular, are not able to use the capacity they have.

Pumping more money into the system is not going to help, however, at least not in the short run, which means orders continue to pile up, while actual production is slowing and prices jump higher. Yes, these should be temporary factors, although at the moment it is difficult to say how long they will last and on energy prices, much will also depend on the severity of this year’s winter, another area where neither monetary authorities nor politicians have much influence.

As Bundesbank President Weidmann already stressed in July “the supply-side bottlenecks of the kind we are seeing for semiconductors might turn out to be more persistent. Catch-up effects because consumption was deferred on account of the pandemic could be more pronounced and give prices a stronger boost. And the initial increase in inflation rates could lead to higher inflation expectations and wage agreements. In addition: if we want to meet the climate targets, there will be no getting around significantly higher carbon prices. That will drive energy prices for many years. What is more, as part of the strategy review we decided, going forward, to incorporate the prices of owner-occupied housing into the consumer price index we use. At present, this raises the inflation rate in the euro area by between 0.2 and 0.3 percentage point. Of course it is possible to take a different view of all these factors, but we do need to keep a close eye on them.”

It seems many have taken the opportunity of lockdowns to take stock of their life and ambitions and the result seems a severe lack of workers in areas that are crucial to the economy, but not very well paid – at least not in comparison to often pretty bad working conditions. Travel restrictions may be getting less common, which in theory should open up the flow of workers from the poorer parts of Europe, but there are signs that even if wage support schemes are phased out, wage growth could accelerate as the pandemic left shortages in key areas and a rise in structural unemployment that will need time to be addressed.

Again, the situation is less severe in the Eurozone than in the U.K., where the implications of Brexit are adding to the wider problem. The shortage of HGV drivers has already caused disruptions to fuel supply and food delivery. Many farmers faced a lack of staff for this year’s harvest and vowed to reduce their target for next year. Livestock is now also affected as there is insufficient staff at slaughterhouses. So price pressures are unlikely to go away any time soon, unless the U.K. manages to import very cheap products to supplement their own reduced production, and even then the lack of lorry drivers will still cause problems. Prime Minister Johnson wants to address this by calling on companies to lift wages in order to attract more local workers into professions that haven’t been very popular for a while now. That is not a short term strategy, and will create just the type of second round effects, central bank’s will want to avoid of course.

Not surprising then that the BoE sounds much more hawkish than the ECB and is increasingly flagging the possibility of early rate hikes, with the central bank’s new chief economist – Pill – saying today that the current spike in U.K. inflation looks set to last longer than originally thought. The ECB has also reduced asset purchase targets, but its interest rate, which is already lower than the BoE’s is set to stay at current levels for some time to come, if the new guidance is anything to go by. Not that monetary tightening would help much, but keeping the foot on the accelerator, at a time when bottlenecks are the main problem, will only add fuel to the fire of inflation pressures. In the case of the ECB though it is becoming increasingly clear that it is not a drive to boost full employment, but the incentive to allow governments to cheaply refinance an ever increasing debt mountain that is keeping the central bank stuck with extreme monetary accommodation. In the meantime monetary policy differences will likely add to further spread widening at the long end and should favour Sterling over EUR.

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