Eurozone Inflation, Monetary Policy, and Ukraine

The Eurozone inflation figures for February have proven to be a “negative surprise” in the words of European Central Bank Vice President Luis de Guindos. Released on the 2nd of March, they show that overall inflation rose to 5.8% in February, up from 5.1% the prior month. Most forecasts had pegged the level between 5.4 and 5.6%, and core inflation had even been on a downward curve, as European economies tentatively return to normal post-Omicron, but this trend was reversed. The highest national inflation within the region remains in Lithuania, which hit 13.9%, whilst the Bundesbank cautioned that German inflation may average 5% over the coming year. There is not a single country in the European Union achieving the ECB’s 2% target.

These 20-year highs have led to a U-turn regarding EU monetary policy. Up until late February, there had been an expectation that the ECB would ‘normalise’ its policy ahead of schedule, but this now seems out of reach. This normalisation was expected to entail two major shifts in the bloc’s control of the money supply. Firstly, the expected interest rate hike from -0.5 up to 0%, which the market had priced in. Secondly was the rapid scaling back of quantitative easing, with the ECB expected to slash its bond purchasing to net zero. The aforementioned inflationary climate, only exacerbated by the extraordinary events in Ukraine, have led to such expectations being dashed almost universally.

The main driver of inflation in Europe right now is surging commodity prices, in particular those relating to energy markets. Oil and gas have already been sitting near-record levels, and the recent period of high winds and increased wind turbine outputs has done little to ease this pressure. There was a 31.7% increase in energy prices in February, outstripping the already exceptional 28.8% rise the previous month. Uncertainty over the Russian position on Ukraine drove up energy futures, and the full-scale invasion that commenced on the 24th of February has caused prices to shoot higher still. As of Friday 4th March, Dutch gas futures had almost broken 200 EUR per megawatt-hour, Brent Crude surpassed 119 EUR a barrel and thermal coal broke 400 EUR per ton. Energy companies have implemented a near-total embargo on Russian oil, without formal government intervention, leaving 70% of Russian crude unable to find a buyer. As Russia is the largest single provider of all the aforementioned fuels, and a similar embargo has yet to come into force on gas, prices are likely to remain highly volatile for the near future.

Furthermore, the invasion has dragged down animal spirits across the region. ECB Chief Economist Philip Lane predicted a 0.3 to 0.4% reduction in Eurozone economic output as a direct result of the conflict. Concerns about stagflation, where growth stagnates whilst inflationary pressures mount, are becoming more pronounced. European GDP growth has been net negative since 2017, and many countries, such as Germany, are yet to return to pre-pandemic productivity levels. In addition to this, Katharina Utermöhl, Senior European Macroeconomist at Allianz, has cautioned that sanctions against Russia could push the EU into a recession.

The ECB will next week release economic forecasts for the coming two years, but central bankers, economists and market makers seem to have come to the consensus that a rate hike will not happen soon and that any monetary tightening should occur amid a supply shock. Paulo Gentilioni, the EU Economics Commissioner has predicted that Brussels will wait two months before re-assessing and then deciding whether to reimpose budget rules in 2023. Several ECB council members, too, have said that the hit to consumer confidence, as well as damper on growth that the war has provided, should necessitate a delay in tightening. The German government has made clear that they wish for the bank to ‘hold its nerve’ on withdrawing stimuli, and markets seem to agree also. Government bonds across Europe rallied on news of the Russian invasion, as investors bet that central banks would be forced into delaying a rate hike as a direct result and looked to profit.

In conclusion, the risk of stagflation, combined with a still-febrile military crisis in the direct vicinity of the Eurozone will most likely encourage an abundance of caution when it comes to the normalisation of monetary policy. Any tightening would be a major risk for the ECB to take during a supply shock.

Analyst: Otto Rutter

Sector Head: Edward Raftery

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