The transatlantic inflation divide

Lower eurozone inflation means interest rates on hold while US and UK rates rise

21 September 2021 Chris Hare, Senior Economist

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Inflation is back – but for how long and how much depends on where you look. Higher US and UK inflation rates look set to translate into interest-rate increases but we expect lower eurozone inflation to keep rates there on hold.

US consumer price inflation rose above 5 per cent in July, largely driven by driven by energy and car prices plus higher services costs. Those factors have lifted UK inflation above 3 per cent too, but less so in the eurozone, where goods prices have played a relatively bigger role in driving the pick-up.

There are transitory factors such as commodity prices, including oil, plus global supply disruption and localised re-opening effects whose timing and magnitude will differ. But we think more persistent macroeconomic divergences will leave medium-term eurozone inflation below US and UK rates.

These include employment: Anglo-Saxon labour markets look tighter, more subject to mismatches between workers and vacancies, and more inflationary.

UK underlying annual pay growth is already between 3.5 per cent and 4.9 per cent. By contrast, despite labour shortages, German pay deals imply growth of around 2 per cent – and below 1 per cent in the important metals and electricals sectors.

Pandemic-related caution and work support schemes are discouraging job moves, but as these schemes wind down, people will return to work or seek new positions, which should allow some labour shortages to ease.

Nevertheless, there is a risk that workers seek higher compensation for filling vacancies, but we expect US, UK and eurozone unemployment to remain above pre-pandemic levels into next year, with significant near-term falls only in the US. The end of eurozone short-time work schemes might raise unemployment.

This should check wage growth. Our central forecasts see UK and US wage growth in 2022 around 3 per cent, which if productivity growth is 1 per cent is broadly consistent with meeting 2 per cent inflation targets. But our eurozone forecast is closer to 2 per cent, consistent with inflation below 2 per cent.

However, there is a risk that, on both sides of the Atlantic, labour-market mismatches and associated wage inflation proves more persistent. Those risks might be bigger in the UK, where Brexit has affected the supply of labour from continental Europe and resistance is growing to the ‘gig’ economy and zero-hours contracts.

We think eurozone wages, and inflation generally, will remain below US and UK levels because it is less dependent on low-cost labour and has not run into the same degree of capacity constraints. Further, pay is more often set by wage indexation than in Anglo-Saxon economies, so reflects past inflation rates. But even inflation expectations remain below US levels and beneath the eurozone’s 2 per cent goal.

Our central inflation forecasts are consistent with expectations that US interest rate rises begin in mid-2023 and two UK hikes next year – but no eurozone rate rises for the foreseeable future. However, the risks of more persistent inflation are greater for the US and, especially, for the UK, giving even wider medium-to-long term inflation divergences that could mean interest rates there rising more quickly.

First published 9th September 2021.

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