On the Eve of a Small Currency War
Europe is gradually bidding farewell to high inflation, though the process is slower than desired. However, the era of rapid price increases could return due to the rising costs of electricity, gas, and food. Against this backdrop, news of slowing inflation and strong retail sales in the United States brings little comfort to Europeans, despite already leading to a rise in the euro's exchange rate. This increase in the euro’s value is only partially beneficial, as it negatively impacts export opportunities. While imported goods, including fuel, gas, and other items, will become slightly cheaper in the eurozone, the situation regarding prices in the EU, particularly in the eurozone and the UK, has seen inflation rise slightly. And this is not particularly good news.
Price increases matter because they directly affect supermarket and fuel station receipts, as well as utility bills. But that’s just the immediate impact felt by everyone. Beyond that, there’s the reaction of businesses to price expectations. Corporations and small firms make decisions about hiring new employees and setting wages for those already employed based on these price expectations.
Why This Matters So Much
Recently, the European Central Bank (ECB) conducted a survey to analyse how new inflation forecasts influence companies’ plans regarding employee wages and the prices of goods they bring to market.
The findings revealed that companies anticipating higher inflation in the future tend to pre-emptively raise their prices even further. They also plan for higher future costs, including wage increases.
Ordinary consumers also react to the prospect of rising prices. In anticipation of price hikes, people are more likely to take out loans to purchase necessary items. Saving? That’s more of an option during times when prices are slowing, and when interest rates on savings significantly outpace the inflation rate.
The better someone understands these connections between statistical figures and their own wallet, the wealthier they become. But it's not just about statistics. Central banks try to curb inflation—not necessarily out of kindness, although that might play a part. To do this, central banks typically adjust the key interest rate, which they change periodically based on the state of the economy.
When inflation accelerates, central banks raise the key interest rate, but this tool is not without its drawbacks. Raising the interest rate tends to slow the economy and reduce employment. Therefore, central banks must strike a balance between trying to control inflation and wanting to maintain stable economic growth.
These changes in central bank policies affect almost everything: prices, job availability, wage growth rates, and the value of national currencies relative to others. It’s worth keeping an eye on this, as ECB research has shown.
Why We Need to Watch Central Bank Interest Rates
We find that consumers adjust their interest rate expectations following the path of monetary policy. However, CES (Consumer Expectation Survey, approximately 20,000 participants each month) data reveal that consumers with a high level of financial literacy adjust their perceptions of whether it is a good borrowing or saving environment more quickly than those with a low level of financial literacy. This is in line with other economic literature which points to the importance of financial literacy in terms of economic outcomes and expectations.
Therefore, the way monetary tightening affects consumers’ actions is not only dependent on information reaching consumers but also on their level of financial literacy. This in turn implies that improving financial literacy could have the potential to support the translation of central bank policies into actions by consumers.
By Evangelos Charalambakis, Omiros Kouvavas and Pedro Neves. ECB
Where is the EU Now? At a Crossroads
According to Eurostat, consumer prices in the eurozone rose by 2.6% in July compared to the same month last year. This is an increase from June's figure of 2.5%. Notably, 2.5% was the average forecast by analysts surveyed by Bloomberg for July. In other words, not only did prices accelerate slightly in July, but the reality turned out worse than predicted.
How should we view this 2.6% rise in prices over the past 12 months? It depends on what we compare it with. The previous year, 2023, ended with inflation at 2.9% annually, following 2022, which saw a staggering 9.2% annual inflation rate. The sky-high inflation of 2022 necessitated very tough measures from the ECB, as mid-year inflation had reached a double-digit rate—10.6% annually in October.
To combat inflation, the ECB began raising interest rates in July 2022. Over the next 14 months, until September 2023, the key interest rate rose by 450 basis points, from -0.5% to 4%. This helped bring down the overall inflation rate in the eurozone from its peak of 10.6% to 2.6% by May 2024. However, after June's annual rate of 2.5%, the process not only stalled but even began to show a reverse trend, as we can see. It’s worth noting that the ECB’s target inflation rate is 2% per year.
In March 2024, ECB President Christine Lagarde warned that the period of high interest rates was coming to an end. As she promised, in June, the ECB lowered rates by 0.25 percentage points, confident that the inflation trajectory towards slowing down would continue. But by July, the ECB realised that the situation was not as favourable as it seemed at the beginning of the summer, so it decided not to reduce rates further. The main refinancing rate was left at 4.25%, the marginal lending rate at 4.50%, and the deposit rate at 3.75%.
Photo: European Central Bank President Christine Lagarde is unlikely to cut key rates in September. The euro has a chance to remain strong against the dollar. Source: Getty Images
Now, we await the August data for the ECB to make its next decision at the meetings on 11-12 September. Just a month and a half ago, investors were confident that the ECB would continue to lower rates. But now, many expect that this may not happen against the backdrop of possible sustained or accelerating inflation in August.
If the ECB is forced to maintain rates at their current level, what will be the outcome? The market has already provided an answer.
On 13 August, inflation data for the US in July was released, showing an annual rate of 2.9%. This is lower than June’s 3% and below the 3% expected by experts. This more rapid deceleration of inflation gives the US Federal Reserve (Fed) room to lower the key interest rate in September if there’s a need to stimulate the economy, particularly to boost employment.
Expectations of further rate cuts in the US, combined with the need to maintain rates in the eurozone, led to a rise in the euro against the dollar. On 13 August, the euro was worth $1.0931, and by 14 August, it had risen to $1.1019, though there was a slight correction to $1.1011 on Thursday, 15 August. This is the highest level since 2 January this year.
The British pound also strengthened under similar circumstances.
The Pound Gets Heavier
In the UK, inflation also turned out to be somewhat unexpected, just as in the eurozone. On 14 August, the Office for National Statistics (ONS) announced that the Consumer Prices Index (CPI) rose to 2.2% annually after it had fallen in June to the Bank of England’s desired level of 2.0%.
This is the first acceleration of inflation since December 2023. If by the end of 2023, inflation in the UK was 4% annually, it gradually slowed down until May. In both May and June, inflation stood at 2% annually. Now, we see a reversal of the trend.
The largest contribution to the monthly change in the annual CPI rate came from housing and household services, as gas and electricity prices fell less than they did a year ago.
“Inflation ticked up a little in July as, although domestic energy costs fell, they fell by less than a year ago. This was partially offset by hotel costs, which fell in July after strong growth in June,” said Grant Fitzner, Chief Economist at the Office for National Statistics.
These figures were released after the Bank of England cut rates from 5.25% to 5% on 1 August. This was the first rate reduction since March 2020. Recall that at the beginning of the COVID-19 pandemic, the Bank of England slashed rates to stimulate the economy, bringing them down to as low as 0.1% annually. However, as inflation began to rise rapidly, the Bank started increasing rates until they reached 5.25% in August 2023. They remained at this level until the beginning of August this year. This was the highest level in 16 years.
As with the euro, investors were guided by the prospects of further rate cuts in the US but maintaining the current rate in the UK. Additionally, on 15 August, quite positive data on the growth of the British economy was released, showing a 0.6% increase in the second quarter of 2024. This was slightly below the 0.7% growth seen in the first quarter of 2024, but still strong and in line with economists’ expectations.
Thus, on 15 August, the pound also rose by 0.2% against the dollar, reaching $1.2856 per pound. This is how the markets have factored in the likelihood that the Bank of England, like the European Central Bank, is inclined to keep the key interest rate at its current level amid the potential reduction of the key interest rate by the Federal Reserve.
Photo: The EU and the UK have learned the hard lessons from the 2022 energy crisis. They have reorganised supply chains and are no longer dependent on Putin’s gas whims. Source: Getty Images
A Shopping Basket Full of Risks
The biggest risks for price increases are usually associated with utilities and the cost of a basic shopping basket.
Everyone remembers all too well how, due to Putin's manoeuvres, Europe was left with a meagre gas supply in the autumn 2022. This issue was compounded by challenges in wind energy. As a result, the cost of electricity and gas soared to obscene heights, which was the key reason inflation in Europe was so severe. In the UK, inflation peaked at 11.1% annually in October 2022, the highest level in 41 years, followed by an 18-month decline. The eurozone faced a similar situation: inflation reached 10.6% in October 2022, followed by a gradual slowdown in price growth. These events occurred against the backdrop of the energy crisis in the second half of 2022.
At present, there are no grounds for a similar scenario. Over the past two seasons, European energy companies have been vigorously replenishing gas reserves in storage. Additionally, in 2023-2024, the infrastructure for the maritime import of liquefied natural gas (LNG) expanded at a rapid pace.
The situation with the shopping basket is more mixed. The US Department of Agriculture (USDA) predicts that wheat production in the EU has decreased due to heavy rains in France, the largest wheat producer in the EU. However, as in 2023, supplies from Ukraine are expected to prevent a significant price increase. The outlook is less favourable for maize—the most popular grain for feeding livestock and poultry. A dry summer in EU-producing countries, as well as in Serbia, Ukraine, and Russia, may lead to higher maize prices, which could, in turn, cause the prices of meat, poultry, dairy products, and eggs to rise.
There is also a risk of an increase in the price of vegetable oil, particularly sunflower oil. Although global oilseed production is forecasted to grow in the 2024/25 marketing year, according to the USDA, this will primarily be due to increased soybean and rapeseed production. However, sunflower seed production is expected to decline due to the July drought in Ukraine, Russia, some EU countries, Turkey, Serbia, and Moldova.
Therefore, keeping prices close to the desired 2% by the end of 2024 will remain a very challenging task for both the UK and EU countries. The strengthening of the euro and the pound will somewhat help achieve this goal, but the same strengthening will negatively impact employment and wage growth. In short—troubles are possible, but they are unlikely to be severe.