Week of September 5, 2022

• Europe on the front lines of an energy crisis
• European inflation accelerates. ECB likely to tighten further.
• US job growth decelerates but remains strong

Europe on the front lines of an energy crisis

• Russia state energy company Gazprom has halted deliveries of gas through the Nord Stream 1 pipeline. Gazprom initially said the gas will be halted for only three days due to maintenance, but as of late last week it announced the halt will be indefinite. Russia’s government claims that Nord Stream 1 production is stifled by sanctions that have limited access to equipment needed to repair or maintain the pipeline. Ukraine claims that Russia can easily boost transmission of gas through Ukraine if needed given that only 40% of capacity is being used. In any event, the current situation has alarmed energy consumers in Europe, worried about whether the gas will be turned back on. They are also worried about the volume of gas that will be supplied during the cold winter months. Meanwhile, all Gazprom deliveries to France have been halted over a contract dispute. 

Germany, meanwhile, has managed to accumulate a high level of gas reserves. Still, this has entailed a significant conservation effort in Germany, including having many manufacturers halt production. Robert Habeck, Germany’s economy minister, said that “it is not good news because it can mean that the industries in question aren’t just being restructured but are experiencing a rupture—a structural rupture, one that is happening under enormous pressure.” He said that companies ranging from small to large across many industries are experiencing “sheer angst.” 

Meanwhile, German finance minister Christian Lindner said that the government is working on a relief package for German consumers. Still, this won’t bring factory activity back. As such, Germany and other European countries face a supply constraint that will very likely push the continent into recession. If, for example, a German chemical factory cannot operate because of a lack of gas, this will have reverberations throughout the supply chain, both upstream and downstream, affecting output and employment. This is just one more instance in which geopolitical events threaten to undermine economic activity, something to which the world is quickly becoming accustomed. Until just a few years ago, this had not been a factor in business for many decades.

• In any event, Europe faces an energy crisis that is clearly worsening, even though natural gas prices fell sharply in recent weeks. The decline in prices came about following news that Germany had been more successful in stockpiling gas reserves than previously expected. Still, gas shipments from Russia remain very low and uncertainty continues regarding Russian intentions during the coming cold winter months. Meanwhile, with Russian shipments down, Norway is now the biggest supplier of gas to Western Europe. In addition, the extremely high temperatures this summer resulted in increased demand for electricity combined with lower water levels. The latter limited the ability to generate electricity from nuclear and hydroelectric plants and limited the capacity to ship energy commodities on inland waterways. 

Despite the recent decline in natural gas prices in Europe, electricity prices continue to soar, leading EU leaders to discuss emergency measures meant to stifle the increase. In Germany, for example, the spot price of electricity has risen sevenfold since June. Forward prices have risen even further on expectations of disruption. The rise in electricity prices is contributing to the acceleration in consumer price inflation. It is now widely expected that the EU will report annual inflation above 9% for August. It is also expected that this number will continue rising in the months ahead, thereby putting added pressure on the European Central Bank (ECB). 

EU Commission president Ursula von der Leyen said that the way in which electricity prices are determined needs to be changed. She said, “We need a new market model for electricity that really functions.” Specifically, she and others are talking about reducing the link between gas prices and electricity prices, although with not much specificity. However, Italian prime minister Mario Draghi has talked about imposing a cap on prices. He said that he wants European governments to agree to cap the price they pay to Russia for natural gas. This will force Russia to accept that price or not provide gas at all. Draghi pointed out that the absence of such a cap has not prevented Russia from stifling the transmission of gas. Therefore, no harm will likely come from imposing a cap. At the urging of the Czech Republic, the EU intends to discuss Draghi’s proposal. Meanwhile, Draghi said that Italy will be free of Russian gas by the end of 2024 as it transitions to other sources, mainly liquid natural gas. 

Interestingly, it is the fear of even higher energy prices that has fueled a sharp decline in the value of the euro, despite increasing expectations that the ECB will tighten monetary policy further. It is reported that the volume of investor bets against the euro has surged lately. Investors evidently believe that a likely further surge in energy prices will fuel accelerated inflation. All other things being equal, if inflation is higher in Europe than in the United States, it will lead to a decline in the euro versus the dollar. Currently, the euro is roughly at parity with the dollar for the first time in 20 years.

• Despite sanctions, Russia has enjoyed relatively high revenue from oil exports since the invasion of Ukraine due to higher oil prices. The world’s richest countries want this to change. As such, the G7 and the EU have agreed on a mechanism to enforce a cap on the price paid for Russian oil. Economists call this situation a monopsony, whereby there is effectively only one buyer in a market. With such buying power, the single buyer can dictate the price. The mechanism by which the price cap will be implemented will involve an incentive system. That is, for an importer to seek insurance and shipping services from companies domiciled in the EU, the United States, or Japan, they will have to abide by the price cap established by those countries.

A specific cap has not yet been agreed upon. The G7 countries issued a statement saying that “the price cap is specifically designed to reduce Russian revenues and Russia’s ability to fund its war of aggression whilst limiting the impact of Russia’s war on global energy prices. The initial price cap will be set at a level based on a range of technical inputs and will be decided by the full coalition in advance of implementation in each jurisdiction.” The more countries that participate in the cap, the more effective it will be in reducing Russian revenue. Russia has already sought to boost exports of oil to other countries such as China and India. Russia warned that the cap will destabilize the global oil market.

European inflation accelerates. ECB likely to tighten further.

• Inflation continued to accelerate in the 19-member Eurozone in August. The EU reports that, in August, consumer prices were up 9.1% from a year earlier, a record increase, and up 0.5% from the previous month. Once again, energy played the biggest role. Energy prices were up 38.3% from a year earlier and were unchanged from the previous month. The stability of energy prices from July to August is welcome, but likely misleading. Oil prices continued to fall globally while European natural gas prices fell due to the ability of Germany to boost reserves of gas more than anticipated. Still, there remains a considerable likelihood that gas prices will rise yet again, depending in part on what Russia does. Also, food prices were up 10.6% from a year earlier and up 1% from the previous month.

When volatile food and energy prices are excluded, core prices were up 4.3% from a year earlier and were up 0.5% from the previous month. Prices of nonenergy industrial goods were up 5% from a year earlier and up 0.8% from the previous month. Prices of services were up a modest 3.8% from a year earlier and up 0.4% from the previous month. While annual nonenergy and nonfood price increases were modest, monthly increases accelerated, suggesting the possibility that underlying inflation is worsening. That explains the evident intention of the ECB to tighten monetary policy more than previously expected. Concern about inflation and expectations of further ECB action led to further increases in European bond yields.

Meanwhile, inflation varied by country. Some of the smaller economies in the Eurozone experienced negative monthly inflation in August. On the other hand, the highest annual inflation, by far, took place in the three Baltic states. Here are the numbers for selected countries:

Country        M/M (%)    Yr/Yr (%)

Germany         0.4                  8.8

France              0.4                  6.5

Italy                  0.8                  9.0

Spain                0.1                 10.3

Netherlands    2.3                 13.6

Belgium            1.8                 10.5

Portugal        –0.2                   9.4

Ireland             0.1                    8.9

Austria          –0.2                    9.2 

Finland         –0.4                    7.6

Greece           –0.3                   11.1

• At Jackson Hole, Wyoming, recently, many of the world’s central bankers met to discuss issues and exchange ideas. Speeches were given and papers read. The main conclusion that can be drawn from the proceedings is that, on both sides of the Atlantic, the zeitgeist is decidedly hawkish. In fact, on the day before the central bankers met, there were actual hawks in the lobby of the hotel where the meeting would soon take place. An omen, perhaps? In any event, although the biggest news was made by US Federal Reserve chairman Powell’s very hawkish speech, there were also hawkish comments coming from two of the leaders of the ECB. 

The two ECB officials who spoke were Isabel Schnabel from Germany, who is a member of the ECB Executive Board, and Francois Villeroy de Galhau, who leads the Bank of France, a member of the Euro Area system. Schnabel said that “central banks are likely to face a higher sacrifice ratio compared with the 1980s, even if prices were to respond more strongly to changes in domestic economic conditions, as the globalization of inflation makes it more difficult for central banks to control price pressures.” The sacrifice ratio is the amount of pain to the real economy needed to achieve a particular inflation goal. In other words, she said that, to achieve lower inflation, there may be a need for worse growth and employment performance than would otherwise have been the case. 

Moreover, in the case of the Eurozone, this is likely to be the case simply due to the huge impact of higher electricity prices, something that the ECB cannot directly target. Thus, for the ECB to achieve its goals in the face of energy disruption, it will likely have to tighten more than otherwise, thereby creating the conditions for recession. That is unrelated to the risk of recession coming from a potential cut-off of Russian gas.

Meanwhile, Valleroy de Galhau said that “our will and our capacity to deliver our mandate are unconditional.” In other words, he intends that the ECB will be entirely focused on hitting the inflation target regardless of the cost. He said that this is an important component in anchoring investor expectations of inflation. Moreover, the ECB has a single mandate to target low inflation, unlike the Federal Reserve, which has a dual mandate to target inflation and employment. Schnabel added that, if a central bank “underestimates the persistence of inflation—as most of us have done over the past one and a half years—and if it is slow to adapt its policies as a result, the costs may be substantial.” 

These comments were hawkish and likely meant to prepare investors for what is coming, especially after a period in which the ECB has been cautious about tightening monetary policy. That caution stemmed from a belief that Europe’s inflation is largely an energy phenomenon as evidenced by relatively low core inflation. Plus, the ECB had the view that it could not influence energy prices and that severe tightening would add to the economic costs of the energy crisis. The views expressed above suggests a shift in the ECB’s thinking, with less concern about recession risk.

Finally, although leading central bankers expressed confidence that they can bring inflation down, even at the cost of recession, it was noted at Jackson Hole that the pandemic has left the world with persistent obstacles. Gita Gopinath, first deputy managing director of the International Monetary Fund, said that the very high inflation was first caused by supply chain disruptions that have not yet gone away. She noted that there is “disorderly global supply chain restructuring” taking place that could be affected by the desire to diversify supply chains. She also noted that the postpandemic labor supply is uncertain, a factor that could influence inflation. And she pointed out that the climate transition also poses risks to price stability. Consequently, central banks will have to take these factors into account as they navigate a new world.

US job growth decelerates but remains strong

• Job growth in the United States decelerated in August but remained strong. Participation in the labor force increased significantly faster than employment, resulting in a small increase in the unemployment rate. Job growth was relatively strong across a wide range of industries, but not in the leisure and hospitality sector, which had accounted for a large share of job growth in the past two years. The September 2 report by the US government might be described as a goldilocks report: not too hot, not too cold. Investors responded accordingly, modestly driving up equity prices and driving down bond yields. 

The US government releases two reports on the job market: One based on a survey of establishments; the other based on a survey of households. The survey of establishments indicated that there were 315,000 new jobs created in August, a robust number but lower than the 526,000 jobs created in July. For the first time, employment exceeds the prepandemic level. However, due to a sharp decline in participation, employment is well below the prepandemic path. That is, absent the pandemic, if there had been steady job growth since early 2020, employment today would be much higher than it currently stands.

Employment grew at a healthy pace in many industries. This includes construction, manufacturing (but not automotive manufacturing), retailing, and financial services. Job growth was very strong for professional and business services as well as health care. Regarding leisure and hospitality, growth was good but not at the blistering pace seen earlier as the economy came out of the pandemic. 

The report also indicated that wages remained tame in August. Average hourly earnings of workers were up 5.2% from a year earlier, the same as in the last three months and lower than in the previous three months. Thus, wages are not accelerated, merely rising. In addition, earnings were up 0.3% from the previous month, the lowest monthly rate since April. From the perspective of the Federal Reserve, this is good news in that there is not currently a wage-price spiral that could exacerbate inflationary pressures. One could argue that the Fed has been successful in anchoring expectations of inflation. Still, the modest wage increases remain surprising given the tightness in the labor market. From the perspective of workers, however, the news is not good. It means that workers are losing ground as wages fail to keep pace with prices. Yet, notably, consumer spending has remained steady due to rising employment, due to the ability of consumers to dip into their accumulated savings.

The separate survey of households found that, due to a sharp rise in the participation rate, the size of the labor force increased much faster than the civilian working-age population. Moreover, although employment grew at a brisk pace, it did not keep pace with growth of the labor force. Thus, the unemployment rate rose from 3.5% in July to 3.7% in August. This remains one of the lowest rates in the last half century. Meanwhile, the participation rate matches a high reached in March, which was the highest since the pandemic began—but it remains well below the prepandemic level. The rise in August is welcome at a time when the vacancy rate is historically high.