Inflation: too early to sound the all-clear

Both headline and core inflation in the US have fallen month on month. In the eurozone, however, inflation remains on an upward trajectory. Although Germany, for example, saw a temporary dip in inflation, this was purely attributable to one-off effects. Conditions in the capital markets thus look set to remain uncertain.

The markets breathed a big sigh of relief when the data revealed that US consumer prices had risen less sharply than expected in July. Following a rise of 9.1 per cent in June, year-on-year inflation in July came to only 8.5 per cent, lower than the rate of 8.7 per cent that the market had anticipated. Core inflation remained stable at 5.9 per cent, compared with an expected rate of 6.1 per cent. The sizeable drop in headline inflation was mainly driven by a fall in energy prices of almost 5 per cent month on month. Air fares and prices of pre-owned cars, which had also been pushing up inflation in recent months, came down as well.

US: trend has shifted in a positive direction but needs to solidify

This is good news for the US economy, although it is still too early to sound the all-clear. For the moment, price pressures are easing, but the crucial question is whether inflation will continue to fall over the longer term. By historical comparison, inflation is still at a very high level. Nonetheless, the data for July has likely reduced the risk of the US Federal Reserve implementing another interest-rate hike of 75 basis points. Union Investment’s baseline scenario assumes that the Fed will raise interest rates by 50 basis points in September. The interest-rates cuts that the market is currently pricing in for the coming year do not seem likely to Union Investment’s economists. But if the downward inflation trend is consolidated, this will improve the chances of a soft landing for the US economy.

Additional support is coming from the fiscal policy front. Last week, the US Congress approved a third economic stimulus package. Together with the two other recent packages, it will bring total government investment to more than a trillion US dollars. This injection should give the US economy the boost it needs to accelerate its transformation and strengthen the competitiveness of domestic industries, especially compared with China. Union Investment’s experts see this as confirmation of their prediction of a long-term investment boom that will increase the US economy’s potential for growth significantly over the next decade.

  • Highs for the year expected to be reached at different times

    US inflation expectations* are falling,…

    Highs for the year expected to be reached at different times
    *Two-year inflation swap Sources: Bloomberg, Union Investment, as at 12 August 2022
  • Highs for the year expected to be reached at different times

    …making a soft landing more likely for the US

    Highs for the year expected to be reached at different times
    Sources: Bloomberg, Union Investment, as at 12 August 2022.

Eurozone: easing of pressures still a distant prospect

Unlike in the US, inflation in Europe is not yet expected to plateau, let alone fall. In July, inflation climbed again to 8.9 per cent, the highest level since the euro was introduced. This was mainly driven by energy prices, which were up by 39.7 per cent year on year in the reporting month. The greater dependency of Europe – and, above all, Germany – on Russian gas or, alternatively, more expensive gas imports from other sources, means that the situation in the European energy market is unlikely to improve any time soon. Broad-based price increases due to rising demand for gas from ‘friendly’ sources such as Norway are also hitting European countries such as Spain that have historically imported little to no gas from Russia.

In Germany, inflation slowed down in June and July. However, this does not mark the beginning of a trend reversal but rather reflects one-off measures such as a temporary fuel tax cut and subsidised rail travel cards for €9 per month, both of which will be phased out at the end of August, and the suspension of the renewable energy levy. In the fourth quarter of 2022, inflation is expected to hit double digits in Germany. Many German households have energy supply contracts with long fixed-price periods, which means that utility companies in the country have not yet been able to pass on the high producer prices to their customers to the necessary extent. In the autumn, gas prices for consumers are likely to double or even triple, which is due in part to a gas surcharge being brought in by the government. Gas producer prices had temporarily increased tenfold. Consequently, gas prices will keep inflation in Germany and Europe at a high level, even though other commodity prices have already reached or passed their peak.

Gas prices will keep inflation in the eurozone high

Although inflation in Europe should gradually abate in 2023, upward pressure on gas prices will remain strong and the resulting high production costs for energy providers will filter through to the prices of other goods and services. Eventually, this will be reflected in the core inflation rate, which is likely to linger at an elevated level even when headline inflation starts to drop.

In addition to high energy costs and concerns about shortages in the winter, low water levels in rivers such as the Rhine are also beginning to cause problems. For companies like BASF, receiving deliveries of commodities such as coal or oil, which are typically transported by ship, could become challenging and much more expensive or, in the worst case, impossible.

Against this backdrop, inflationary pressure is not expected to ease any time soon and it seems unlikely that the European Central Bank will reconsider its planned interest-rate hikes, even though the eurozone economy is already floundering. As a best-case scenario, Union Investment’s economists predict stagnating growth for the eurozone and a mild recession for Germany. But the risk level remains high Conditions in the capital markets will thus remain highly uncertain and volatile for the foreseeable future.

 

As at 12 August 2022.

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