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Europe gets nervous

Omicron is spreading and inflation rising: central banks must not misjudge their reaction.

European inflation started rising early in 2021 and exceeded policymakers’ predictions. Central banks that confidently asserted it would be temporary are now getting nervous. The European Central Bank has turned hawkish; the Bank of England has already raised interest rates.

Real-terms incomes in 2022 will be squeezed by higher inflation driven largely by non-discretionary items, such as energy and food.

However, our central case is that eurozone inflation peaked last year. Unless wholesale energy prices keep rising, last year’s increases will eventually drop out of the annual inflation rate and if global supply disruption eases in 2022, other cost pressures should also fall. So with little evidence of significant eurozone wage growth, we see inflation ending 2023 close to the ECB’s 2 per cent target.

The UK may have to wait a little longer: we expect consumer-price inflation to peak at 6.0 per cent in April, but still to be back below target by mid-2023.

The Bank of England raised interest rates in December 2021 to 0.25 per cent. It was a bold move against a backdrop of significant uncertainty but we forecast three more rises by August 2022, taking bank rate to 1.0 per cent.

The European Central Bank still intends to end net purchases under the Pandemic Emergency Purchase Programme in March. Even with additional purchases under its regular Asset Purchase Programme, this implies a surprisingly steep taper in total net purchases.

So although the ECB still forecasts sub-target inflation in 2023 and 2024 – 1.8 per cent in both years – we think it will look to end net asset purchases completely in the first half of next year. This would pave the way for a 10 basis-point increase in the bank’s deposit rate in September 2023 – its first key policy rate rise since 2011.

However, there are risks. Omicron is spreading and protracted supply-chain disruption could put pressure on goods prices. Labour markets are tightening. Rising minimum wages, particularly in Germany and the UK, could further push up costs.

But central banks should be even more concerned about rising inflation expectations. These could shift quite quickly but even a gradual drift higher, if ignored, can lead to runaway inflation. In the 1970s, taming it meant large rises in interest rates, leading to recessions and high unemployment.

If inflation expectations rise, the Bank of England might tolerate a prolonged period of above-target inflation to hiking rates aggressively and causing recession. However, the ECB’s choice is more complex: a sharp tightening could widen differences with the periphery countries and pile more pressure on some highly indebted countries.

But although Omicron has prompted further restrictions, vaccination and treatment improvements mean the economic impact may be smaller than in previous waves. Economies have adapted and may now cope better, and the experience of 2020 and 2021 suggests that activity will quickly recover provided governments offer similar levels of business and labour-market support.

Even so, we have nudged down our 2022 growth forecasts for the eurozone to 3.8 per cent with the UK cut to 4.5 per cent. But we have raised our 2023 projections slightly, to 2.2 per cent for the eurozone and 1.8 per cent for the UK.


First published 5th January 2022.

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