As food and energy prices surge, the previously cooling inflation in the Eurozone faces an uncertain direction. With this rise, will the European Central Bank's hawkish stance persist?
A recent report led by Nomura's Chief Economist Rob Subbaraman suggests that the risk of inflation is increasing for most economies, given the continuous rise in energy and food prices. Many countries' inflation rates remain well above their target levels. If this spike in commodity prices is driven more by supply than demand, it could result in starker stagflation consequences. Not only does the hike in commodity prices intensify Consumer Price Index (CPI) growth, but it also undermines economic growth. Without a rise in demand, increases in food and energy prices can diminish household purchasing power and corporate profits.
Commodity-importing and/or low-income economies are most vulnerable, with food occupying the largest share of their consumer baskets. For these fragile economies, an escalation in inflation could be accompanied by weakened economic growth, rising trade costs due to higher import costs, and deteriorating fiscal conditions. In extreme scenarios, worsening economic fundamentals could set off a vicious cycle: escalating inflation, capital flight, and currency devaluation may force central banks to dramatically hike interest rates, further dampening economic growth.
Data shows that since June 30 of this year, prices for everything from grains to energy have been on an upward trend, driven largely by supply constraints. If food and energy prices rise by 20% by year-end, apart from the Bank of Japan, most central banks might maintain higher interest rates for a more extended period. In Europe, Italy and Spain appear to be the most vulnerable.
Will Supply-Driven Inflation Return?
In July, while the U.S. saw overall Consumer Price Index (CPI) rise and core inflation decrease, showing the smallest consecutive monthly growth in over two years, fostering market optimism. The Eurozone's harmonized CPI for July was 5.3%, down from 5.5% the previous month, with a 75% market bet on the European Central Bank pausing its interest rate hike in September.
However, the recent upticks in food and energy prices may challenge the declining inflation trends in Western countries. If consumers raise their inflation expectations, it could further impact core inflation.
Lately, news of tightening supply in the crude oil market has pushed international oil prices higher. As of Friday, August 11, international oil prices have seen a seven-week consecutive increase, the longest streak since 2022. The latest monthly report from OPEC forecasts a potential supply gap of more than 2 million barrels per day this quarter, with global oil demand set to grow by 2.44 million barrels per day this year. OPEC suggests that the oil market outlook for the second half of the year looks "very healthy."
Ongoing production cuts by countries like Saudi Arabia and Russia have continually driven up oil prices since late June. J.P. Morgan predicts that by September, oil prices might reach $90 per barrel. Analysts, including Natasha Kaneva, mentioned in a report that the oil price is expected to keep climbing from its current level, targeting $90 per barrel, as key market indicators suggest that the spot market is tightening quickly.
Nomura's report states that the U.S. oil demand is surging dramatically, with commercial flight numbers hitting record highs. Rising temperatures are leading to increased use of air conditioning and electricity, which could likely drive up energy prices further.
Coincidentally, the natural gas market has also been volatile. Strikes at Australian natural gas plants have triggered European energy alerts. Bond traders fear the European Central Bank might adopt a more hawkish stance. Reports from Bloomberg suggest that ING Group, Rabobank, and SocGen anticipate the European Central Bank to adopt a hawkish stance as energy prices surge again. Officials aim to curb long-term inflation expectations from continually rising. ING's Senior Rate Strategist, Benjamin Schroeder, pointed out that inflation alarms are ringing again, emphasizing the persistent risks to inflation dynamics from recent gas price volatility.
Beyond energy supplies, geopolitical tensions and the El Niño effect may disrupt global food supplies, leading to skyrocketing food prices. On July 17, Russia announced its exit from the Black Sea Grain Agreement, which allowed ships to travel through specific Black Sea routes, safely exporting grains globally from Ukrainian ports. By July's end, the IMF's Chief Economist suggested that geopolitical crises restricting grain trade could massively impact global food supply, potentially raising wheat prices by over 15%.
Amid the effects of El Niño, India's rice and sugar yields have suffered. As the world's largest rice exporter, to ensure domestic food supply and stabilize local grain prices, India has decided to halt most rice exports. There are market concerns that India might extend this to sugar. Due to insufficient rainfall, the Thai government has reduced rice cultivation to conserve water. Since June, Thai rice prices have surged by 25%, marking the highest level since 2008. Nomura believes that while food protectionism might be justifiable for an individual country, if multiple countries adopt similar protectionist measures, they could unintentionally amplify global food price risks. Similar events occurred between 2007-2008 and 2010-2011.
What impact will the economies of Western countries have?
Nomura Securities believes that the surge in commodity prices generally has a smaller negative impact on Germany's economy, but with Germany's higher CPI, the impact cannot be ignored. The biggest concerns are the negative impacts of rising food and energy prices on Italy and Spain. Meanwhile, the Federal Reserve will pay more attention to inflation expectation surveys, which are a significant factor in driving core inflation.
To assess the economic impact and the potential policy responses of central banks in various countries, Nomura used the following assumption: By the end of the year, food and energy prices will rise by 20% from the level in early August (e.g., this would push Brent crude oil prices to around $100 per barrel).
Looking at the U.S., a 20% rise in U.S. energy and food commodity prices could lead to a significant acceleration in the overall U.S. CPI inflation.
In the U.S. overall consumer price index, household food prices consist of grocery items and energy prices account for 4.8% and 7.0%, respectively.
Specifically, food retail prices seem to have a higher downward rigidity compared to commodity prices, and the effect of commodity price changes on food retail prices tends to lag. Despite this uncertainty, a continuous 20% increase in energy and food commodity prices could still push the overall U.S. CPI up by 2 percentage points.
From the perspective of the Federal Reserve, we believe that the FOMC may overlook the overall CPI rise driven by commodity prices since core inflation (excluding food and energy components) has historically been a better predictor of future inflation.
However, considering the public's perception of inflation's significance in dynamic inflation data, rising essential goods prices could raise consumer inflation expectations, leading to rising inflation.
Nomura notes that, based on the New York Fed's consumer expectation survey, the median three-year inflation expectation seems to be influenced by consumers' views on food and energy prices rather than rent or medical service prices. Similarly, the University of Michigan's 5-10 year inflation expectation seems sensitive to gasoline prices, and higher inflation expectations could affect core inflation through wage negotiations or increased corporate pricing power.
We believe the Federal Reserve will pay closer attention to inflation expectation surveys as they are indicative of how commodity price rises could drive core inflation higher.
For Europe, Nomura found that in Belgium, Spain, and Italy, the proportion of food and energy prices in the HICP basket is higher, while in the UK, Austria, and Germany, the proportion is lower (the proportion of food in the HICP basket is highly correlated with the proportion of energy in the HICP basket).
Considering consumer risks regarding food and energy and the potential impact of extreme weather events on production, Nomura's greatest concern is the negative impact of rising food and energy prices on Italy and Spain. France, Germany, and the UK are in a better position, but among these countries, France might be the most stable due to its lower dependence on fossil fuels:
A 20% rise in energy and food prices may not necessarily trigger fiscal reactions similar to last year's surge in natural gas prices.
Moreover, monetary policy has already tightened significantly, so further aggressive rate hikes seem less likely. Nevertheless, in the process of curbing inflation, a new round of commodity price hikes suggests that interest rates need to be maintained at higher levels for a more extended period.
As Huw Pil, Chief Economist of the Bank of England, recently said, the central bank "will respond to this." Thus, if tight monetary policy significantly suppresses consumption and economic activity, the risk of Europe entering a recession becomes higher.
