In Europe, Little Energy Relief

By Bas van Geffen, Senior Macro Strategist at Rabobank

Governments across Europe have announced measures to cap utility bills and reduce energy use. The European Commission told national governments to find ways to cut electricity demand by 10%, and several member states have announced their own plans to shield households and/or businesses. So far, these measures appear to have at least some impact on gas prices. The European benchmark has been on the decline after peaking halfway last week, although 1 month ahead prices remain at very elevated levels compared to their historical rates.

Interestingly, however, this decline seems to do little for other markets. The 5y5y EUR inflation swap has hardly budged, and if anything the contract quotes a little higher – despite the lower gas prices. And equities remain on the backfoot. Clearly, markets are getting increasingly sceptical that such measures will do much to alleviate inflationary pressures, except for shifting them from the short- to the medium-term, perhaps. Indeed, in contrast to the European contract, the US 5y5y inflation swap has come down somewhat – arguably reflecting the Fed’s more proactive stance against the recent bout of inflationary pressures.

In other words, even as governments are unveiling their support measures, central banks’ inflation fight is far from over. In fact, as we argue below, their job could become that much more difficult. Markets are therefore starting the week as they ended last week: equities are lower and rates are drifting higher ahead of a week packed with central bank meetings.

Week ahead

Amidst the as of yet uncontrolled global surge in inflation, we’ve got no less than seven major central banks setting policy this week. Coming up are the PBOC and Riksbank on Tuesday, the Fed on Wednesday, and on Thursday the Bank of Japan, the Bank of England, Norges bank and the SNB.

The outlook that the Fed might slow down to 50bp clips is well behind us, and some are even considering that the US central bank could add a full percentage point to its target rate. Our US strategist acknowledges that there are risks that the FOMC could go for 100bp to signal their resolve to fight inflation and to keep expectations in check. Nonetheless, he believes that the FOMC will stick to a 75bp hike this month.

Now, this is not the time to cheer for those expecting the Fed to pivot or slow down in order to save their stock portfolios. We expect the FOMC to follow this up by a fourth 75bp hike in November, which has us estimating the terminal rate at 5% by early 2023. What’s more, we don’t see how the Fed can reverse any of these hikes before 2024. Although the exogenous shocks of supply chain disruptions may fade soon enough, the wage-price spiral may keep core inflation elevated – which would make the path down for inflation a slow grind.

While other countries aren’t yet dealing with a similar wage-price spiral, inflation is becoming increasingly broad-based. And as much as they may want to help the population, governments could become part of the problem.

Last week, the European Commission presented a plan to siphon ‘excess’ profits from power companies to electricity consumers – either households or businesses hit by the surging utility costs. And in the UK, PM Truss unveiled a plan to cap utility bills for an average UK household at levels well below those computed by the UK energy regulator earlier. However, this also means that consumers will feel less of the pinch, and that aggregate demand may not moderate as much as it would have.

Don’t get me wrong, support is necessary. Particularly for the increasing number of households that has to choose between a warm home and a warm meal. Demand destruction is an awful, academic way to describe the hardship many people are currently going through. Yet, the impact of offsetting fiscal support cannot be ignored. If households are left with more cash to spend –as little as it may be– that will find its way into demand for other goods. Goods that Europe may not have the energy for to produce.

There are two lessons to be drawn here. First, where will governments draw the line? Again, it is hard to argue against policies that ensure people don’t freeze or starve to death. But how much fiscal relief is required? And what if the subsequent extra demand raises the price of clothing, of kitchen tools, of furniture? Sure, these price increases are of a different order of magnitude than the astronomically high energy bills. Yet, it illustrates how governments may not be in the position to solve the burden of inflation unless they find a way to solve the energy shortages – and rationing and redistribution are no solutions. Governments can only take the sting out of it in the near term. This also argues for very targeted intervention.

Secondly, it means that any government intervention that goes beyond that which is absolutely necessary could have negative repercussions in the form of more persistent inflation. The extent to which inflationary pressures become entrenched hinges on the amount of fiscal support and how well-targeted it is. Central banks will have to take this into account as they continue to push back against inflation becoming more entrenched.

With that in mind, UK Prime Minister Truss’ plans to cap utility bills at £2,500 should reduce inflation by nearly 5 percentage points, and plans to support businesses will keep the job market tighter than it would have been if companies had been forced to shut their doors due to the energy costs. That, however, risks shifting the UK’s inflation from what was mostly an external headwind to domestically generated. It also changes the profile of inflation significantly. Energy-driven inflation will now certainly be significantly lower in the near-term, but it will probably lead to more persistent, demand-driven inflation in the medium-term – though the latter isn’t yet a given.

Our UK strategist therefore believes that Truss’ policies make a 75bp hike this week unnecessary, and believes the Bank of England will raise rates by 50bp. However, the prospect of more entrenched inflation also reduces the scope for the Bank to reverse some of its tightening next year, and we have therefore removed the rate cuts we were predicting for 2023H2 from our expectations for UK rates.