However, Europe is now facing other inflationary challenges. The most obvious problem is the Ukraine war which boosted energy prices by almost 40% year-over-year in July and which threatens to cause more disruption this winter as Russian gas supplies dwindle. In addition, Europe has faced the unwelcome effects of a strong dollar with the Euro/USD exchange rate falling from $1.23 at the start of 2021 to $1.03 today. This has exacerbated the commodity price surge for European consumers as global commodities are generally priced in dollars.
Going forward, barring a sudden collapse in the U.S. dollar or a ceasefire in Ukraine, it is possible that inflation will remain more stubborn in the Euro Zone that in the U.S. However, it is still likely to drift down in the year ahead with slower economic growth, monetary tightening and a loosening of supply constraints.
In July, the European Central Bank announced a 0.5% increase in its deposit rate, bringing it back to zero and signaled that there would likely be a further increase at their next meeting on September 8. While the ECB cannot impact most of the factors that have led to higher European inflation, continued rate hikes, in an environment where the Federal Reserve begins to take a more dovish stance, could lead to an appreciation of the Euro, combatting at least one source of Eurozone inflation.
At her press conference at the end of the ECB Governing Council meeting on July 21, the President of the ECB, Christine Laguarde reinforced the messaged that the ECB’s policy will continue to be data-dependent and would help them deliver on their target of 2% inflation in the medium term. In contrast to the Federal Reserve, these data may well justify no relaxation in the ECB’s recently more hawkish stance between now and the end of the year.
United Kingdom: No Easy Choices
The U.K. is, if anything, facing a more daunting inflation challenge than the United States or the Eurozone. CPI inflation was 9.4% in June and this Wednesday’s retail price report should reveal an even sharper increase in July. Moreover, because of the lagged effect of higher natural gas prices on consumer utility bills, the Bank of England is currently forecasting that inflation will peak at over 13% in the fourth quarter of this year.
U.K. inflation, like that in the Euro Zone has been boosted by higher energy prices. However, labor market statistics are tighter in the UK with a 3.6% unemployment rate in May (which may have fallen further in June) and a 6.2% year-over-year increase in wages. Sterling, like the Euro, has fallen sharply over the past year relative to the dollar, contributing to higher imported inflation.
The inflation outlook in the U.K. is further complicated by the current Conservative Party leadership race with both candidates promising fiscal stimulus to shield consumers from the negative income effects of higher utility bills. This extra deficit spending should reduce the risk of a five-quarter recession projected by the Bank of England under current fiscal policies. However, it would further worsen the public finances in the U.K. and could pressure the Bank of England into more aggressive tightening.
In early August, the Bank of England increased Bank Rate by 0.50% to 1.75% in a sixth consecutive rate hike and suggested that a further rate hike, of perhaps the same magnitude, could be on the cards for its mid-September meeting. Unlike the Fed or the ECB, it looks like the Bank of England may have to combat an expansionary fiscal policy in its attempts to get inflation back to its 2% target. Moreover, as it made clear in its August Monetary Policy report, it is determined to achieve this goal, even if it means putting the U.K. into recession. As Andrew Bailey, the Governor of the Bank of England stated at his August 4 press conference, there are “no ifs or buts in our commitment to the 2% target.”
China: Problems Beyond Inflation
China’s inflation rate, in contrast to Europe and the United States, remains relatively tame. Consumer prices rose 2.7% year-over-year in July, up from 2.5% year-over-year in June, while producer prices backed off to 4.2% year-over-year compared to 6.1% in June. The yuan has fallen by roughly 6% relative to the U.S. dollar since March. However, this largely reflects the global appreciation of the dollar—on a trade-weighted basis the Chinese currency has been relatively stable year-to-date.
Inflation in China will likely remain relatively subdued in the near term largely because of significant pressures slowing demand. While the government has signaled some modification of its zero-covid policies, attempts to prevent a major Omicron outbreak will likely continue to hamper economic growth. The housing sector continues to struggle with major over-supply, falling prices and developer debt. This not only directly impacts housing activity but it has knock-on effects on consumer financial positions, local government funding and supplier industries. In addition, China’s huge export industries are being threatened by a global slowdown.