The European Central Bank equation to exclude the scenario of stagflation in the euro area

Are we heading towards a long period that combines weak growth and the phenomenon of high prices? In other words, are we heading toward stagflation like the one that followed the oil shock of the early 1970s? While French foreign trade insurer Coface indicated on Tuesday that it has not ruled out any scenario for the global economy, the European Central Bank estimated on Wednesday that it does not believe it is “not at all likely” that stagflation will start in the eurozone. As a reminder, we are talking about stagflation with a long period of low growth and high inflation, which in this case will continue until the end of 2023. However, the European Central Bank hopes that its policy of raising key interest rates will lead to lower prices. It is currently counting on a 6.8% price increase in 2022, then 3.5% in 2023, while lowering its growth forecast over this period.

Soft landing ‘looks ‘increasingly unlikely’

Christine Lagarde, President of the European Central Bank, confirmed on Monday the institute’s intention to raise interest rates twice in July and September, the first in more than 10 years, if Covas does not rule out any scenario (between recession and stagflation and even deflation) she believes nonetheless That a “soft landing” appears “increasingly unlikely”. In the first quarter, the slowdown in activity in developed countries and stagnation or even a decline in GDP in Europe “were figures of even greater concern because the economic consequences of the war in Ukraine were just beginning. It feels ‘feel’ and that conflict ‘went on for what not’ end,” Covas summed up on Tuesday, while introducing the second quarter barometer.

change the tone

She added that while the global economy “appeared to be grappling with the threat of stagflation a few weeks ago, a change in the tone of central banks, in the face of accelerating inflation, raised the specter of stagflation, particularly in advanced economies.”
Covas added that while “it may be a bit too early to confirm the global economy has entered a stagflationary regime, there are many signs in this direction” and “no scenario can certainly be ruled out”.
“What we have in mind is a soft landing scenario – which central banks want, which still seems possible but increasingly unlikely – a stagnation scenario and in the medium term a scenario where we experience stagnation and, given persistently high prices, stagflation We are at a crossroads,” summed up Jean-Christophe Cave, Chief Economist of Covas, during a press conference.

“I will add the deflation scenario that goes along with the recession scenario, we haven’t talked about it for ten years, but it may come with it, especially if things go wrong in Europe,” he added.

Looking at 18 months, Covas’ “central scenario” indicates a significant slowdown in activity, allowing inflation to decelerate very gradually. Our growth outlook is particularly poor in developed countries. Coface notes that it has revised its assessment of “business default risk” by country: it is higher in 19 countries (out of 126), including 16 in Europe – Germany, France, Spain and the UK in particular – and lower for Brazil. and Angola, given the context “favorable to exporters of raw materials, especially oil”.

WhyBanks may be worried about hyperinflation

Higher interest rates will only benefit banks if inflation is quickly contained, according to a study published Thursday by Oliver Wyman, a less likely hypothesis. The work of strategic consulting is based on three scenarios and details of their results, more or less positive, on the banking sector. The first, called a “soft landing,” which holds that central banks succeed in containing inflation without impeding growth, is more favorable to banking players.
Banks should particularly benefit from increased profit margins due to higher interest rates and continued strong loan production. The cost of the risk must remain reasonable.
But this option is less likely, the study authors believe.

“The war in Ukraine is putting a little more pressure” on inflation in the short term, Elie Farah, head of French financial services at Oliver Wyman, told AFP.

Inflation in the United States, for example, was 8.6% in a year in May, according to the Consumer Price Index (CPI), when inflation in the eurozone reached 8.1% in a year in the same months, according to Eurostat.

“Structural factors such as the need to move towards energies that are not necessarily very cheap” suggest that “this inflation is not just something that will disappear immediately,” continues Elie Farah.

He therefore calls on banks to take a closer look at the second scenario, which is built on initially weak inflation and a more aggressive reaction from central banks “at the cost of slower economic growth in 2023-24, currency volatility and disruption of international trade.”
Banks will then see the cost of risk increase in addition to their current expenses.
The latter scenario raises the specter of stagflation, a prolonged period of weak growth and high inflation that would “severely” hurt the banking sector.
Elia Farah warns that monetary tightening on the other side of the Atlantic could also tip institutional investors in favor of the US, “which could have more negative consequences for banks and the economy.”

(with AFP)