Why Europe’s inflation is different

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Good morning. I bragged about the arrival of summer in the last letter, and New York City responded with a 95 degree day, bringing with it the city’s seasonal perfume, the smell of hot garbage. Markets, appropriately, drooped a bit. No more weather talk, then. Email us: [email protected] and [email protected]


After the eurozone printed record inflation yesterday, Tyler Cowen had some questions. Why, the economist asked at his excellent Marginal Revolution blog, is European services inflation, at 3.8 per cent in May, running so hot? In the absence of a jumbo-sized American fiscal stimulus package, the European inflation story so far has been about scarce energy. But why should that spell pricier services?

Good questions. So we put them to a few sharp minds on the eurozone. Here are some answers.

First and foremost, hot eurozone inflation is still about energy. Energy prices pass into other prices. This is plain to see in the spread between eurozone headline and core inflation. Pull out food and energy, and eurozone inflation drops four percentage points:

Yet eurozone core inflation, while below the US’s, is still hot by any past standard. What began with energy and food has broadened, as the FT’s Chris Giles explained to us:

What’s happening is a direct hit from natural gas prices and petrol — and then moving from that to everything else.

With energy stubbornly expensive, inflation in services categories such as transport and housing have picked up. But there is another piece to this. Prices in areas such as recreation, hotels and restaurants are rising fast too, as Europe enters its first post-Covid summer in several years. Supply is still clearly the dominant factor, but demand is starting to matter too:

Column chart of Eurozone consumer inflation categories, month-on-month % change showing Non-energy feeling the heat

This might look uncomfortably close to US inflation, where narrow pandemic-specific inflation gave way to broad price increases. But the comparison is imprecise. For instance, Europe is seeing some goods inflation in areas such as vehicle prices, but nothing like the American dash for used cars. Much of Europe’s goods inflation is imported, while the US experience was all about roaring demand.

The biggest difference is in employment and wages. Tight US labour markets (alongside oodles of excess cash savings) are supporting high demand. Not so in Europe, where household consumption in the key eurozone economies has not recovered from the pandemic, as Tomas Hirst pointed out on Twitter yesterday. Hours worked are below pre-pandemic levels too, suggesting labour market slack. Wages aren’t yet a big part of Europe’s inflation story.

In sum, the big picture looks like demand-pull inflation in the US and cost-push inflation in Europe. But until Russia’s war ends, the energy and food crunch probably won’t let up. So the European Central Bank will have to tighten.

Markets expect the ECB to move fast, pricing in 100 or so basis points of rate increases by the end of 2022, according to Bloomberg. The central bank is likely worried that a weak euro, by raising the cost of imports, could worsen inflation even more.

With the Fed already hiking briskly, the ECB doesn’t have much time. As Claus Vistesen of Pantheon Macro told us:

We’re just now getting to the panic stage. Markets are now realising, and the ECB is also now realising, that [the central bank hasn’t] done anything up until now.

Rising energy and food costs mean Europe is likely headed for serious slowdown, if not a recession. How deep or long one could be is unknowable. But the central bank hiking into that slowdown can’t be good news for European risk assets. (Wu & Armstrong)

Bank loans are growing again 

Regular readers will know that we tend to rattle on about market liquidity, and how important it is to risk asset valuations. Lately the news on the liquidity front has been bad, and it will get worse when the Fed starts shrinking its balance sheet. That could start happening today! But there is one source of liquidity that is going solidly in the right direction: bank lending. US banks have added about $180bn in net new commercial loans since October:

Line chart of Commercial & industrial loans, US banks, $bn showing Bank lending is back

That big spike in the middle of the chart, at the outset of Covid, is every company in America drawing down its revolving credit line just in case they might need a little ready money (they didn’t). The important bit is the move up on the right, which is suggestive of economic growth and expanding liquidity. Remember that bank lending — as any economics bore will be happy to tell you — creates money. 

This is good news, so long as inflation keeps rolling over at the same time and the Fed doesn’t get even itchier than it already is. It is all the more striking because in the year or so before the pandemic, bank lending was not growing at all.

Scale is important. Remember that the Fed’s plan is to absorb cash, by selling bonds or letting them mature, to the tune of $47bn a month starting this month, and moving up to $95bn a month. Net new lending of $30bn a month or so won’t offset that entirely. But it ought to help. 

What is driving the growth? According to all the analysts I spoke to, part of the loan surge is just good old-fashioned economic growth. “The reopening trade continues,” Barclay’s Jason Goldberg told me.

There are additional complexities, though. Another part of the story is the build-up of inventories (or is it hoarding?) we’ve recently written about. Here for example is JPMorgan’s head of commercial banking on a call with analysts:

We’re seeing very healthy loan growth. Clients have become much more active. They’re beginning to build inventory in part because of supply chain disruption, but in large part because of higher economic activity.

The inventory build won’t last for ever, and there is a case to be made it could reverse with unpleasant speed. 

There are still more wrinkles to contend with. Anton Schutz, a bank investor at Mendon Capital, pointed out to me that the bond market is not booming like it was, so companies are turning to their banks (US corporate bond issuance is down 27 per cent year to date versus 2021, according to Definitive). Further, Schutz noted, the last of the Paycheck Protection Program loans are expiring and being paid off by the government, falling off banks’ balance sheets. So underlying loan growth might be even higher, especially at small banks.

A final aspect was suggested to me by Charles Peabody of Portales Partners. Profit margins are falling from the pandemic highs, as Unhedged recently wrote. This means it is harder for companies to finance investment out of profits. If they want to invest, they might have to turn to borrowing. 

The moral of the story is twofold. First, while we may be headed into an economic slowdown, plenty of indicators are pointing the opposite way. Second, at the moment, every economic indicator has to be interpreted in light of the various hangover effects of the pandemic. There is always a subtle underlying story.

One good read 

Many readers will be aware of the great Stuart Kirk ESG kerfuffle. My view on Kirk is hopelessly biased: Stuart has been a close colleague and friend of mine for a long time, and his pot-stirring delights me. That said, it seems fair that I point out Tariq Fancy’s level-headed take on the furore.

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