Rising European gas price extremely unwelcome

The People's Bank of China (PBoC) cuts interest rates, the US Federal Reserve keeps interest rates unchanged, while the European Central Bank (ECB) raises them. In addition, the rising European gas price is extremely unwelcome.

These divergent decisions by the Chinese, US and European central banks clearly show how different conditions are in the three economic blocs. US inflation has since fallen to 4,0% (year-on-year) in May. A peak of 8,9% was reached in the middle of last year. A further fall in inflation is on the horizon. After ten rate hikes in a row, the Fed is now marking time. In his explanation of the interest rate decision, Fed boss Jerome Powell made it clear that the peak of official interest rates has not yet been reached as far as the Fed is concerned.

Sixteen of the eighteen members of the policy committee foresee one or more further rate hikes before the end of the year. Of course, that raises the question of why the Fed didn't just raise interest rates now. You can compare it to mooring a boat. As the dock approaches, the boat slows down. The Fed had already downgraded from 75 basis point rate hikes to 50 basis points, and the last three rate hikes have been 25 basis points. By leaving interest rates unchanged for now, the pace of interest rate hikes will be further weakened. Incidentally, Powell rightly emphasized that the expectations within the policy committee should not be seen as intended policy.

Three phases
Powell also reiterated the three phases he identifies in monetary policy, aimed at bringing inflation under control. Initially, it was mainly about the pace of interest rate hikes. That phase is now closed. The second phase is about finding the level of interest rates that is sufficiently restrictive to bring inflation under control. The Fed is now in that phase. This is followed by the third phase, in which the central question is how long interest rates should be kept at the highest, restrictive level in order to get inflation to the 2% target on the one hand and not push the economy into an unnecessarily deep or long recession on the other.

The first picture shows inflation in the US. There is clear evidence of a decline, but the latest figure is still clearly above the target of 2% and core inflation is also well above that at 5,3%. Incidentally, the Fed mainly focuses on the price index for Personal Consumption Expenditures, excluding food and energy.

The second picture shows three major components of inflation. In this period, energy prices fall in the year-on-year comparison. That depresses inflation. In May, energy prices took off about 0,8% of inflation. In June that will be even more because energy prices rose sharply in June last year. Food price inflation has also been falling for several months. This is due to a fall in international prices for agricultural raw materials and lower energy prices. Food prices react to this with some delay. A further reduction in food price inflation is on the horizon.

In the second picture I also included the 'cost of shelter', let's say rent. With a weight of almost 35% in the US inflation basket, rents have a major influence on the inflation rate. As I have often argued, rents follow house prices with a significant lag of more than a year. Rents are still about 8% higher than a year earlier, but a moderation is also on the horizon here. House prices have been falling for some time and that will affect rents. I'll have to keep an eye out for this one. Mortgage interest rates have now stabilized for a while and that seems to be leading to some recovery in the housing market. If that recovery continues, the reduction in rent increases may be disappointing.

China is following a very different path
The Chinese economy has long followed a very different path from ours or the US. When our inflation rose sharply, Chinese inflation remained low. Last year, the Chinese authorities followed a strict lockdown policy because they could not get the corona virus under control. As a result, economic growth fell far short of expectations and ambitions. That zero-tolerance policy has now ended and society and the economy have reopened, but the recovery of the economy has so far been quite disappointing.

For example, the level of industrial production in May was only 3,5% higher than last year. In April it was still 5,6% and that too was actually lower than you might expect. The pace of retail sales growth slowed from 18,4% yoy in April to 12,7% in May. Earlier, the foreign trade figures were published in May and they also clearly fell short of expectations. The combination of disappointing growth and very low inflation has prompted the People's Bank of China to cut interest rates slightly. Other policymakers will also try to support activity. It does raise the question of why the recovery of the Chinese economy is so disappointing. The most obvious answer is that aggregate demand is just weak. What that says about the global economy is not yet clear.

The ECB is not ready yet
As expected, the ECB raised its interest rates for the eighth time in a row. President Christine Lagarde made it clear that the ECB is not ready yet. Another interest rate hike will undoubtedly follow at the end of July. The ECB started raising interest rates later and has also raised rates less than the Fed so far. Not that this is an absolute benchmark. In the explanation, Lagarde said that the development of unit labor costs ultimately determines inflation. I fully agree. The rise in unit labor costs now inconsistent with the 2% inflation target.

A major setback
A new and major setback is imminent for us. The European gas price is rising again. Before the pandemic, prices of €15 to 20 MWh were normal. The following graph shows that prices already increased during the course of 2021. After the outbreak of war and the boycott of Russian gas, the price briefly rose to almost €350 MWh in August last year, a twenty-fold increase! Subsequently, the European gas price started to fall.

The next picture zooms in on the development this year. The decrease from around €70 MWh at the beginning of the year to less than €25 MWh was very welcome. This decline dampened inflation, contributed to a reduction in production costs for companies and thus boosted activity. However, the price has now risen to more than €40 MWh, an increase of more than 60%.

If you read the comments, the recent price increase is mainly due to reduced gas production in Norway due to maintenance work and the formal decision to completely end gas production in Groningen later this year. The volatility of the gas price makes it very difficult for companies to plan. Naturally, this is also annoying for consumers and a sharp increase in the price of gas will put a damper on economic activity. However, I do not venture to make a prediction for the gas price.

Closing
While financial market players earlier this year expected official interest rates in the US to be cut before the end of the year, it now looks very different. In fact, the Fed itself expects to raise rates even further, although it paused this week. Earlier, the central banks in Canada and Australia also paused, only to continue with rate hikes after a few months. The Chinese central bank cut interest rates this week. The recovery in activity has been disappointing after the policy of frequent lockdowns was ended in December last year. I suspect it's down to disappointing demand and that doesn't bode well for the global economy.

The ECB continued to raise interest rates this week, but they started later than the Fed. In the last two weeks, the European gas price has risen again, while it was on a nice slide. Whether that increase will continue or will soon be reversed, I dare not predict. I do know that a new increase in the European gas price is very unwelcome and very bad news. It encourages higher inflation, more problems for households and businesses and puts a brake on economic activity. Hopefully it's only temporary. Fingers crossed.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.