Risks relating to still underappreciated inflation strength and a higher terminal rate

The jump in energy costs has helped push euro-area inflation up to nearly 11% this year, by some margin a record high and over five times the central bank’s target. We anticipate energy inflation to remain higher than in the rest of the world in the coming years given the likelihood of continued tightness in the LNG market. But rising inflation in Europe is not just a commodity-driven phenomenon. Core inflation has risen to 5% and now exceeds US inflation on shorter-term measures of momentum. We think these dynamics are likely to persist, with European inflation remaining much higher than it has over the past 10 to 15 years and potentially higher than the developed market average. The labour market is at record tight levels (Figure 1) and our leading indicators suggest wage growth could rise to 5% – 6% in the coming quarters.

And the deflationary adjustment in the periphery that drove weak euro-area inflation over the past decade is over — domestic inflation has risen above the core level for the first time since 2012 and will be boosted over time by NGEU recovery plan spending.

Market expectations for how high ECB will hike rates have risen significantly, but if we combine our outlook for growth and inflation and apply a simple Taylor Rule — which suggests that to dampen inflation, the real rate needs to rise commensurately — we require a peak rate in the euro area as high as 5% – 6% compared to the 3% priced today. Put another way, without those hikes, it would take a deep contraction of around 6% in GDP next year to get inflation back to the 2% target. It won’t be a straight line there — the ECB is not as singular as the US Federal Reserve (Fed) in delivering its inflation target and has one eye on preventing a disorderly widening of peripheral spreads. Therefore, it may take signs of stabilisation before the ECB even engages with the idea of hiking further, but the inflation fundamentals are consistent with a significantly higher terminal rate.

Pockets of vulnerability

The ECB’s balance-sheet reduction is likely to outpace both the Bank of England and the Fed in 2023 as the loans linked to its targeted longer-term repo operations (TLROs) mature and quantitative tightening begins from early 2023. Combined with large issuance plans, this should put more upward pressure on term premia next year. There are two pockets of leverage in Europe that look vulnerable in this context. The first is Italian sovereign debt, which now exceeds 150% of GDP. Although the new government has presented a relatively sensible first budget, the risk is skewed to higher borrowing than expected. Energy subsidies have only been rolled for one quarter, so if energy prices stay high, the government will be under pressure to keep them going for longer. A second pocket of leverage is the high level of household debt in Scandinavian countries. That should constrain the hiking cycles in Sweden and Norway relative to others and increases the risk of a very sharp downward adjustment in house prices in both countries. We are already seeing evidence of that playing out in Sweden. It also implies a need for weaker currencies as both economies diversify away from domestic-demand-led growth.

A difficult path ahead for the UK

The UK economy also appears vulnerable to further challenges as we head into 2023. The Liz Truss administration was exceptionally short-lived thanks to its “mini-Budget” — a substantial fiscal policy package that was poorly planned, communicated and executed. However, at its heart, the failed mini-Budget tried to address two structural problems the UK has long been grappling with: it has seen virtually no productivity growth since the financial crash of 2008 and its capex spending since 2016 (Figure 2) has been flat or declining.

With new leadership and a radically different budget, fiscal policy has completely reversed the 9% GDP loosening announced in September. While this has addressed immediate market concerns, UK policymakers are having to contend with double-digit inflation, a very tight labour market (mostly driven by contracting supply as increasing numbers have left the workforce due to structural reasons such as long-term sickness) and accelerating wage growth. As the Bank of England has shown it is very sensitive to negative economic growth, this may cause the hiking cycle to stop short of what’s needed to bring inflation back to target. This could prove challenging for sterling, especially if a long recession looms ahead, and ultimately reinforces existing inflationary pressures.

In conclusion, we expect the European economic cycle to remain volatile, with a wide distribution of outcomes, and for inflation to stay uncomfortably high.