The looming risk of Stagflation

Last Updated on Thursday, 26 October, 2023 at 2:17 pm by Andre Camilleri

In the past week, I have dedicated various of my weekly articles on the analysis of Malta’s economy, in the run-up for the upcoming Budget speech. From next week, we will likely dedicate several articles on what was outlined in such Budget speech. So for this week, I would like to focus on the turbulent international business environment and the difficulty that this is posing on policymakers, especially central banks.

When the European Central Bank’s Council meets in Athens on Thursday 26th October, it is expected widely to halt the most aggressive series of interest rate rises in its history, after raising interest rates at its past 10 meetings. It has good reasons to pause. On one hand, the reality is that we are looking at a near stagnation of the eurozone economy this year, with an overall downward trajectory of inflation. On the other hand, the conflict in the Middle East is now pushing energy prices higher, which is another headwind to the battle against inflation. European gas prices are up 35% so far this month, oil is above $93, threatening to push inflation back up. As an energy importing region, Europe is more vulnerable than the United States to an inflation spike caused by Middle East tensions. I believe the ECB would likely buy time to see if this energy related price spikes are going to be sustained into the future.

So far, data is expected to show that the inflation rate in Europe will drop further in October. As I write this article, we are expecting the latest survey of purchasing managers in Europe, whereby expectations are expected to point to further declines in eurozone business activity. Furthermore, the ECB’s own survey of banks is also likely to show that the supply of credit continues to contract. The amount of money circulating in the euro zone shrank by the most on record in August as banks curbed lending and depositors locked up savings. The ECB will likely scrutinise that and other signs of tightening in financing conditions. The surging U.S. Treasury yields, which have now gone over 5% for the benchmark 10 year note, have also dragged up European borrowing costs, supporting the case for no further hikes, just now.

So in essence, a weakening European economy suggests the need for further tightening is limited but the ECB is likely to push back against rate-cut speculation. It will likely have the ECB position itself to keep all options open, for even additional rate hikes in the future, if it deems them necessary. However, we can safely say, that the possibility that the rapid rate hikes that happened so far are likely to remain with us for longer than previously anticipated.

Another element being discuss is whether beyond rate hikes, the ECB will consider quantitative tightening i.e. the selling of the bonds it had bought during the quantitative easing phase and hence the trimming down of its balance sheet. The rising Italian bond yields and the rising spread between the Italian bond yields and the German bond yields, are likely to cool off any idea of having the ECB sell off bonds.

So in conclusion, the risk of stagflation is now on the rise. With European economies in a low economic growth territory and the risk of having inflation fuelled further by the rising energy prices as a result of the Middle East conflict, the risk of having very low economic growth with high inflation is looming on us all.

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