Eurozone faces risk of stagflation

The euro zone has felt the inflationary consequences first, with inflation now up to 10%.

>> Recessionary risks are coming to the fore

It might be easy to say now but the writing has been on the wall for the euro zone since Russia launched its attack on Ukraine back in February, sending gas prices surging and raising questions about the longevity of gas supplies to the region. So far, the euro zone has felt the inflationary consequences first, with inflation now up to 10%. Very soon the full costs in terms of economic growth will be felt as the indicators that have a good track record of predicting recessions, such as the Bank of Italy produced COIN measure, slump to recessionary levels.

Mr. Jeremy Stevens, Asia Economist at the Standard Bank, expects the recession to start in either Q3 or Q4 this year and continue throughout H1:2024. That’s one reason why the Standard Bank’s full-year forecast for GDP in 2023 is -0.5%, compared to the ECB’s latest forecast for 0.9% and the 0.2% consensus amongst analysts in the regular Bloomberg survey. On a brighter note, the weakness in growth could pull average inflation down to 5% next year, which is lower than the 5.5% pencilled in by the ECB.

Although there is a good chance that inflation will fall measurably next year, the ECB is unlikely to take any chances. Indeed, it has already produced more in the way of rate hikes than was anticipated earlier in the year, and Mr. Jeremy Stevens  expects ECB to push on and take the key refi rate to 3% from its current 1.25%. That might seem excessive given that inflation is likely to fall – but the key point is that longer-term inflation expectations have become de-anchored from the Bank’s 2% target, which creates the risk that, while inflation will fall, it will tend to level off some way above the 2% target, even if it temporarily dips below this target over the next year or so. A 3% terminal rate would still be much lower than the Fed or Bank of England, which we see at 4.5%. That’s because Mr. Jeremy Stevens believes that the inflation problem is far more entrenched in the US and UK, with the former paying the price for substantial fiscal expansion during the pandemic, which was not so much of a feature in the eurozone.

Another issue for the ECB to bear in mind is the potential trade-off between aggressive rate hikes and bondmarket fragmentation. For other central banks, like the Fed and BoE, the trade-off is between growth and inflation. Too much tightening risks a deep recession; too little threatens permanently high inflation. The ECB faces the same trade-off. But in addition to this, one should also be aware that a miscalculation on rates could spark a re-run of the bond market crisis we saw between 2010 and 2012 when Greece very nearly left the euro zone.

>> Higher ECB rates won't save the euro

Debt levels are much higher in the euro zone now than they were back then. In 2010 the gross debt of the euro zone was around 94% of GDP; last year it was 122%. The ECB has moved to head off this threat by producing a new antifragmentation tool, the Transmission Protection Instrument (TPI). While its forerunner, Open Market Transactions (OMT), was never used, we believe that bond spreads will widen significantly, and that the ECB will be forced to use its TPI.

Tension in the bond market could spill over to the currency, just as we have seen in the UK recently. Against the all-conquering dollar a slide to the 0.90 region seems likely and, if financial fragmentation really takes hold, a visit to the historic lows around 0.82 could be on the cards. Longer-term hopes for a recovery in euro/dollar rely on a turnaround in the dollar as we doubt that the euro can stage any independent rebound. What’s more, if a weaker dollar is the spur to euro/dollar recovery as economic growth revives, asset prices rebound and the Fed starts cutting rates (or at least stops tightening), this is more likely to aid “riskier” currencies rather than the euro.

“What the euro gains against the US dollar will likely be lost against other currencies such as the Australian dollar, Canadian dollar, Scandinavian currencies and more. While a “natural” turnaround for euro/dollar is our base case in around 6 months from now, we’d not rule out such a turnaround having to be effected by coordinated intervention from the ECB and other significant central banks around the world”, said Mr. Jeremy Stevens.