In September, central bankers had to face the facts: this inflation is too high and too persistent to fight without causing a recession. Some governments, on the other hand, still refuse to admit it. It is in the UK that this antagonism is coming to the fore. Just as the Bank of England was about to reduce its balance sheet to control inflation, the Prime Minister and her finance minister launched a stimulus package so massive that the central bankers had to backtrack. The measures destabilised the UK’s already fragile finances to such an extent that rates on sovereign debt had risen. As for the pound, it has reached historic lows against the US dollar, and has come close to parity.
But it is not only UK Gilts that have fallen out of favour for political reasons. The election of a far-right government in Italy pushed the yield on ten-year Treasuries up to 4.9%. The spread over the German Bund widened to 260 basis points. In spite of the package of measures put together by the ECB this summer, which is intended to contain it. Even the difference between French debt and the Bund has increased.
Euro below parity with the US dollar
These movements underline how difficult the ECB’s task of fighting inflation with rate hikes is. This has put pressure on the euro, to the point where it can no longer regain parity against the US dollar. The disparity of needs within the Eurozone is once again highlighted: some need to avoid too high an interest burden on their debt, others would like to contain inflation as a priority.
Europe is of course also disadvantaged by the fact that it is much closer to the Russo-Ukrainian war than the US. On the energy supply side, stockpiling has progressed better than expected, but the situation remains fragile. It is still to be hoped that the winter will prove to be mild. In these conditions, it is difficult for the ECB to bring inflation down from the current record levels to values closer to its 2% objective, even if it were to intervene in a very determined manner.
German inflation at over 10 percent
In September, the annualised price increase in Germany even exceeded 10% for the first time, at 10.9%. The former export champion is seeing the surplus of foreign goods crossing its borders shrink to a trickle. One of the engines of the euro zone is therefore not in great shape. The German economy, which is heavily dependent on Russian gas, is expected to be in recession for the rest of this year, and even into 2023. For this year at least, France looks set to fare much better, with a growth forecast even raised in mid-September to 2.7%. For 2023, however, the forecasts may prove to be too optimistic: France will not be able to escape the negative effect of the German and British difficulties.
Combating the price-wage spiral
On the other side of the Atlantic, Jay Powell has a much freer hand, also thanks to the dollar’s status as the world’s safe haven currency. He even has to keep raising rates to better control a yield curve that is tending to invert – a sign of recession. The threat of a price-wage spiral persists, as wages continue to rise and the labour market continues to dry up. At the same time, it is this element that raises doubts as to whether the US is indeed already in recession, after two quarters of negative GDP growth. One of the most frequently cited criteria would thus be met.
Test for the “new normal”
Nevertheless, forecasts of the maximum policy rate the Fed will reach have been revised upwards several times. This reflects the disillusionment of Jackson Hole in August, but also the fact that almost a generation of financial market participants has not yet been confronted with a situation once considered normal. The period of low or even negative interest rates has been exceptionally long. This duration has even shaken old certainties, and redefined the level of rates considered neutral. A return to rates above 4% was considered unlikely. And yet, the expected peak of the current upward cycle is well above this limit. On the positive side, growth also seems less constrained than this “new normal” suggests, driven in particular by demographic change.
Oil is not currently a driver of inflation. On the contrary, it has fallen through the 80 dollar a barrel mark for WTI, after peaking at 120 dollars in June. However, Europe remains under pressure from gas prices, which are six times higher than they were a year ago, also making electricity more expensive.
In the US, the PMI for industry is heading in the right direction, with a rise of 0.3 points to 51.8. The PMI for services even jumped by 5.5 points, and remains just below the bar indicating a contraction (49.2 points). In Europe, however, the deterioration continued, to 48.1 points (1.1) for industry and 48.9 points (0.7) for services. These indices thus underline the currently more positive outlook across the Atlantic.
