Christine Lagarde: “If inflation is the genie, then deflation is the ogre that must be fought decisively.”

When Christine Lagarde talked about inflation in 2014 as the Managing Director of the International Monetary Fund, the world and prevailing macroeconomic environment was a very different place to today, with leaders and policymakers more concerned about ogres than genies. Thankfully, no deflationary monsters went on to wreck havoc on the global financial system, but now as President of the European Central Bank, Lagarde’s attention is turning firmly towards keeping a lid on spiralling Eurozone inflation and this genie’s proverbial bottle.

In April, long-term Eurozone inflation expectations –represented below by the German 10-year breakeven inflation rate – edged above its US counterpart for the first time since 2009. For most of the last decade the Eurozone has been struggling with low inflation levels and fending off deflation risks, as secular stagnation (low or no economic growth) and negative interest rates weighed on the spending habits and optimism of consumers and businesses. Eurozone inflation expectations subsequently languished behind US inflation expectations between -0.5% and -1.0% over the period. However, since Russia invaded Ukraine in February this year, Putin’s war on Europe and NATO expansion has caused a surge in commodity prices from oil and natural gas to wheat and nickel, as a new regime of sanctions and supply shocks are priced into markets. Nobody knows what President Putin is going to do next, but sadly this is now looking like a war of attrition where the rising cost to humanity is compounded by the rising inflationary cost to consumers.

The biggest impact will most likely be felt in Europe, not just because of the proximity of the war and the higher proportion of economic trade impacted by it, but also because Lagarde’s ECB will have its work cut out fighting the inflation genie whilst preventing a potentially damaging economic recession to the Eurozone. If the ECB raises interest rates too much or too quickly to combat rising consumer prices that rose 7.5% year-on-year in April, then it risks causing more damage to its increasingly delicate economy. However, if it fails to stop inflation expectations moving even higher and de-anchoring from their long-term range, then real incomes will be squeezed further and consumers will feel yet more pain. Surely then, if there is one monster that will keep Lagarde and her fellow central bankers up at night it is this, the threat of stagflation.

The economy is decelerating from its unprecedented 2021 pandemic recovery speed but is still expected to expand in 2022 at a pace above its long-term trend growth rate. Wage and employment cost growth have also accelerated to the highest levels in the post-Global Financial Crisis era, whilst consumer price inflation is at a 40-year high. However, consumers, corporations, and banks are cash rich, and remain in a good starting position to withstand higher borrowing costs as the Fed embarks on a potentially aggressive tightening cycle.

Economic growth expectations for 2022 are decelerating quickly as sanctions on Russia and escalating commodity prices bite. Consequently, Eurozone inflation expectations have converged with US inflation expectations as the war in Ukraine continues, translating into an energy crisis. French President Macron defeated challenger Marine Le Pen for a second consecutive time and was re-elected for another 5-year term, a positive outcome for the cohesion of the EU.

Rising consumer price inflation is running at 7.0% year-on-year, the highest level since 1992, caused in part by surging energy bills. A triple whammy of rising inflation, increasing interest rates, and higher taxes are expected to hurt household disposable incomes and could cause a cost-of-living crisis, potentially pushing the British economy into a recession this year. The Bank of England warns that consumer price inflation could surpass 10% in the near-term.

Japan’s economic recovery still lags behind other major economies but is catching up and helped by a recently announced large fiscal stimulus package from newly elected Prime Minister Kishida. Headline consumer price inflation has accelerated to above long-term levels and is gathering momentum, but core inflation excluding food & energy prices has fallen back deeper into deflationary territory indicating that most of Japan’s inflation has been imported.

Chinese property curbs and zero covid policy lockdowns have substantially constrained credit demand from the property, consumption and services sectors. However, the credit and aggregate financing cycle is bottoming and tax cuts are being implemented in a sign of policymakers’ determination to stabilise the economy and boost consumption growth. Unlike in most global economies this year, inflation pressures have remained low and benign in China, resulting in the PBoC being the only major central bank to cut interest rates so far in 2022.

Economic growth of the BRITS bloc has been substantially revised down this year, predominately due to a severe invasion-induced recession to the Russian economy which is expected to contract by more than 10% this year.

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