The EU’s latest hare-brained gambit is likely to put further downward pressure on economic activity while exerting further upward pressure on inflation, making stagflation all but inevitable.
Official inflation reached new record highs in the Euro Area in the month of May, clocking in at 8.1%, well above the consensus estimate of 7.7%. In six of the 19 Euro Area countries the “harmonized” (calculated the same way for all countries) inflation rate was in double digits: Estonia (20.1%), Lithuania (18.5%), Latvia (16.4%), Slovakia (11.8%), Greece (10.7%) and Netherlands (10.2%). The three Baltic States, Estonia, Latvia and Lithuania, were the first EU Member States to stop all imports of Russian oil and gas, which they did in early April.
These record-high rates of inflation were all registered before the EU decided (in Yves’ words) “to shoot itself in the foot” by banning shipments of oil from Russia, its biggest oil provider. As such, inflation is likely to rise even higher in the coming months, especially given the central role energy prices have played in driving inflation in Europe. In the last month alone energy prices in the currency bloc have risen by 39%.
At the same time, the European economy is de facto stagnating, according to European Central Bank executive board member Fabio Panetta told Italian daily La Stampa at the beginning of May:
Growth in the first quarter was 0.2%, and would have essentially been zero without what may have partly been one-off spikes in growth in certain countries. The major economies are suffering – GDP growth has slowed in Spain, halted in France and contracted in Italy. In Germany growth momentum is low and has been weakening since the end of February, which is the point when everything changed.
Making Matters Worse
Now, Europe’s political leaders have decided to make matters even worse by further exacerbating its largely self-inflicted energy crisis. As part of its sixth sanctions package against Russia, the EU’s 27 Member States have agreed to ban all seaborne Russian oil, with a temporary exemption for pipeline oil. As a result, roughly two thirds of the oil EU Member States buy from Russia will no longer be available — at least not officially. The Council of the EU said that by the end of the year 90% of Russian oil will be banned.
As Yves said in her piece yesterday, “if you believe the EU really, truly, will have cut its imports of Russian oil by 90% in a few months,” she has a bridge she’d like to sell you. She also pointed out that an “EU ban on oil shipped by tanker still allows for Russian oil to come to Europe via out and out laundering through cut-outs and mixing with non-Russian source product, albeit at a higher cost.” In other words, there is whole lot a lot of puff, bluff and bluster to the EU’s latest escalation.
But that is not to say it won’t cause yet more economic hurt and hardship to the citizens of EU member states that depend heavily on Russian oil to meet their basic energy needs. Before Monday night Russia supplied around a quarter of the EU’s oil. Given tight — and thanks to the EU’s latest hare-brained gambit, tightening — global supplies of oil, Europe will probably struggle to replenish their supplies without resorting to laundering Russian oil through cut outs.
Even then, prices are likely to rise much higher in the coming months. And that is going to put further downward pressure on economic activity while exerting further upward pressure on inflation, which is already at or around decades-highs in many jurisdictions, including the EU.
The impact on Germany, which depends on Russia to meet around 12% of its oil needs, is likely to be pronounced. Yet its government is one of the most vocal supporters of the partial oil embargo. Judging by recent comments from members of the Scholz government, it is perfectly aware of the economic harm the embargo is likely to exact on consumers not only in German but across Europe. But as the FT reported last week, it believes it is a price worth paying:
Europe was prepared to bear the strain of cutting its use of Russian crude, said Robert Habeck, Germany’s economy minister and deputy chancellor. But he said the move should be properly prepared and should consider the high dependency of some EU countries on Russian supplies.
“We will be harming ourselves, that much is clear,” he said ahead of an emergency meeting of EU energy ministers that is debating an embargo on Russian oil.
“It’s inconceivable that sanctions won’t have consequences for our own economy and for prices in our countries,” he said. “We as Europeans are prepared to bear [the economic strain] in order to help Ukraine. But there’s no way this won’t come at a cost to us.”
The Worst of All Worlds
That cost is likely to be stagflation, which is bad news for all EU citizens, particularly those on the lower rungs of the economic ladder. A portmanteau of “stagnation” and “inflation”, stagflation is a situation in which prices don’t stop rising in a sluggish or shrinking economy with a weak job market. Put simply, it is the worst of all worlds. First coined by the British Tory politician Ian McLeod in 1965, the term became popularised during the repeated oil shocks of the early and late 1970s. It was then largely forgotten for the best part of the following 40 years but is now making a big comeback.
As a recent AP article notes, there is no formal definition or specific statistical threshold for stagflation:
Mark Zandi, chief economist at Moody’s Analytics, has his own rough guide: Stagflation arrives in the United States, he says, when the unemployment rate reaches at least 5% and consumer prices have surged 5% or more from a year earlier. The U.S. unemployment rate is now just 3.6%.
In the European Union, where joblessness typically runs higher, Zandi’s threshold is different: 9% unemployment and 4% year-over-year inflation, in his view, would combine to cause stagflation.
Unemployment in the EU is currently 9%, which means that by Zandi’s standards stagflation is not here yet. But one thing that is clear is that across the world prices, particularly for the most basic of goods such as food, accommodation, healthcare and energy, are surging at the same time that many economies appear to be stagnating. There is a whole host of reasons why these two things are happening.
Economies are stagnating due in part to central banks’ recent reversal of more than a decade of ultra-loose monetary policy, in a desperate (and most likely futile) bid to tame inflation by cooling growth. Other factors (and this not remotely an exhaustive list) include the recent withdrawal of many COVID-19 stimulus programs as well as the ongoing supply chain crisis. Rather than abating, the crisis appears to be getting worse, as a trifecta of forces — the recent lockdowns of vital industrial centers and port cities in China, the war in Ukraine and the West’s ratcheting sanctions against Russia — have exacerbated preexisting logistical dislocations and distortions.
In the meantime, inflation is surging for a slew of reasons, including (and again, this is far from a comprehensive list):
- Central banks’ dogged application of ultra loose monetary policies for well over a decade, leading to an unprecedented misallocation of resources and the formation of financial asset bubbles, which have further enriched the asset-owning classes.
- The COVID-19 stimulus programs, both fiscal and monetary, which helped to soften the blow of lockdowns but also led to a huge surge in the broad money supply at a time of significantly reduced economic activity. Inflation was an all but inevitable by-product. As a recent post featured on NC posits, there was also a significant shift in demand from services to so-called “tradable goods.” But as the global economy emerged groggily from the lockdowns of 2021, those trabable goods could not be made or delivered fast enough to meet the surging demand. As the lockdowns were lifted, demand for tradable goods surged at a time that the world was still in the grip of an acute shortage of tradable goods.
- The disruption caused by the war in Ukraine, one of the world’s top-ten grain exporters, and the West’s ratcheting sanctions against Russia, one of the world’s biggest energy and commodities suppliers, has also significantly exacerbated price pressures, as too have natural disasters such as floods and droughts.
Too Little, Too Late?
By March 2022 stagflation expectations in the US were already at their highest since 2009, when the world economy was still being roiled by the global financial crisis, according to a Bank of America report. Three weeks ago, a senior advisor to Germany’s Finance Minister, Christian Lindner, said Germany may already be in the early stages of stagflation. Here’s more from Bloomberg:
A hoped-for pickup in growth in the second quarter after the lifting of pandemic restrictions hasn’t materialized and inflation has exceeded expectations, Lars Feld, a professor of economic policy who advises Lindner, said at a news conference in Berlin.
Germany is “at the very least facing a high risk of stagflation, if not already at the beginning of this stagflation,” Feld said. The government should respond with measures that can help boost capacity, he added.
Since then, inflation in Germany hit another post-World-War-II record high in April, of 8.7% — far higher than the consensus estimates of 8.1%. It is the highest level since Germany’s Federal Statistics Office (Destatis) began publishing the monthly statistics in 1963. In the same month annual producer inflation, which measures changes in wholesale prices, surged to 33.5%, breaking a fresh record high for a fifth straight month. It is also the highest level on record since the Destasis began collecting the data 73 years ago.
So-called “core inflation”, which excludes “volatile” food and energy prices, also rose above expectations, from 3.5% to 3.8%, which is likely to heap yet more pressure on the European Central Bank to begin reversing its ultra-loose monetary policy. And that is where the problems get a whole lot bigger.
Unlike the Fed and the Bank of England, the ECB has not begun raising interest rates from their current level of -0.5%. In fact, its balance sheet, now at €8.8 trillion, continues to expand while benchmark rates remain negative, offering (in the words of the financial analyst Sven Henrich) “the most asymmetric central bank policy position in central banking history, disqualifying the entire ECB Board” led by Christine Lagarde.
Lagarde herself dismissed a year ago concerns about inflation, insisting that rising prices would return to normal by next year, as in this year. That hasn’t happened. On the contrary they have quadrupled, leaving Lagarde and the institution she heads in an almost untenable situation. Former chief economist and board member of the European Central Bank (ECB) Otmar Issing recently rebuked central banks — including the ECB — for their complacent insistence that inflation would be “transitory,” describing it as “probably one of the biggest forecast errors made since the 1970s.”
Painted Into a Corner
Like most large central banks, the ECB has painted itself into a corner. If they begin withdrawing their monetary stimulus, which has fueled one of the largest financial bubbles of all time, there is likely to be a sharp sell-off of stocks, real estate and many other financial assets, in particular high-risk assets such as junk bonds, raising the risk of another financial crisis. This is exactly what happened the last time the Fed tried to increase rates above 2%, in 2018: there was a sharp market sell-off, prompting the Fed to quickly reverse policy.
The ECB’s purchase of over €340 billion of corporate bonds between the summer of 2015 and the end of April 2022 has facilitated arguably the greatest corporate bond bubble of all time, with even the average euro junk bond yield sliding to an absurdly low 2.1% in November 2017. But it’s in the sovereign debt market that the ECB’s asset buying has had its biggest impact. Thanks to its purchase of trillions of euros of Euro Area sovereign bonds, including more than €750 billion of Italian bonds, the central bank has been able to keep the yields on those bonds in check, and by extension the Euro Area intact.
Now that the ECB is talking about ending its asset buying program at some point in the third quarter (i.e. as soon as early July and no later than late September) and then raising interest rates some time shortly thereafter, investors are suddenly beginning to wise up to the fact that arguably the most important force underpinning Europe’s corporate and sovereign bond markets over the past seven years — the ECB’s monthly purchases of corporate and sovereign debt– is about to disappear. The result is likely to be a sharp sell off.
To all intents and purposes, this has already begun. Three weeks ago, the FT reported that European corporate debt had been hit by “its heaviest pullback on record as fears over persistently high inflation and the threat of a recession send traders dashing out of the market.”
Sovereign bond yields are also rising, raising concerns that if the ECB begins tightening financing conditions in the coming months in a bid to tackle inflation, it could trigger spreads between Germany’s sovereign bond yields and those of countries such as Italy and Spain to widen. Risk spreads on Italian 10-year bonds are already above 200 basis points, meaning they are higher today than when Mario Draghi was installed as prime minister by Italian political elites in a desperate attempt to restore political stability.
If spreads continue to widen as interest rates are gradually hiked, as the ECB says it intends to, it will become harder for countries on the periphery to service their debts. As Mr Draghi himself recently warned, “the spreads have been rising in a lot of European countries. This does not disguise the fact that we’re starting from a higher base, and from a public debt stock that is much higher.”
Raising rates at this juncture is also likely to exacerbate stagflationary conditions, squeezing yet more life out of the economy by making it even harder for heavily indebted businesses, home owners and consumers to service their debts. This has already happened in some emerging markets such as Brazil and Mexico where economic activity has slowed after successive rate rises.
At the same time, hiking rates will probably do precious little to actually tame inflation for the simple reason that many of the forces driving inflation, including supply chain shocks and geopolitical tensions, are beyond the control of central banks anyway. The Bank of England has already hiked rates four times since December yet in that time inflation has surged from 5.4% to 9%. Of course, many economists will argue that there is always a time lag in the effects of monetary policy.
But what if hiking rates does little to tackle inflation while unleashing broad-based collateral damage in a regional economy already hit by war and pestilence and which still hasn’t recovered from the global financial crisis. Recent experience in Latin America’s largest economy, Brazil, seems to offer a cautionary tale. Although the central bank has executed 10 rate hikes over the past year or so, pushing interest rates above 12% for the first time in five years, inflation still registered an 18-year high of 12.13% in May 2020.