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Inflation risks trump growth risks for central banks

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The Russia/Ukraine war has entered its third month, without any signs that the conflict will be resolved any time soon. After failing to capture Kyiv, Russian forces are now focussing their attacks on the Donbass region in the Southeast. But despite broadbased devastation, Ukrainian resistance remains strong and we see a risk of further escalation in the coming weeks (see also Research Russia-Ukraine – Several signals point to an escalation in the war in Ukraine as Victory Day looms, 26 April). The war continues to create severe disruption to global supply chains, which is stoking “stagflation” fears. Food price inflation remains high, and oil and gas prices increased after Russia halted gas deliveries to Poland and Bulgaria and stories that EU countries might sanction Russian oil.

The combination of higher energy prices and a weaker growth outlook puts central banks in a tough spot. In particular, China’s economy is faced with renewed headwinds from Covid-19 lockdowns in Shanghai and Beijing, which are weighing on consumer spending and production. Economic activity in the US remains resilient despite the Ukraine war, thanks to ongoing strong consumer spending. However, a tight labour market and stubbornly high inflation (40-year high of 8.5% in March) remain the Achilles’ heel of the US economy, and to address this, we expect the Fed to front-load rate increases and deliver 50bp rate hikes in May, June, and July, and 25bp in September, November, and December (a total of 225bp). Aggressive tightening of financial conditions also increases the risk of recession, especially in 2023, and US mortgage rates have seen a significant rise since the beginning of the year.

Business surveys suggest that the Eurozone economy has weathered the fallout from the war better than expected. Services activity continued to build momentum during April after the lifting of pandemic restrictions and increased spending on travel and recreation. However, growth in manufacturing output nearly stopped as bottlenecks, rising prices, and heightened uncertainty took their toll, especially in Germany. While the economic repercussions from the Ukraine war remained limited in Q1, sharp declines in business and consumer confidence still point to downside risks ahead. With inflation reaching ever new record highs (7.5% in April), a growing number of ECB governing council members are advocating a faster policy normalisation pace, especially amid signs of de-anchoring inflation expectations, which now stand above the 2% goal. With the possibility of further disruptions to Russian gas and oil supply looming as the EU readies another sanctions package, the risks to Eurozone inflation remain firmly on the upside in our view. We now expect a first 25bp hike from the ECB in July, followed by continued hikes in September, December, and March, taking the deposit rate back to 0.5% in Q1 23. Markets are pricing in further 115bp of rate increases for 2023, which we see as too aggressive in light of the fragile state of the global economy and aggressive Fed tightening.

Incumbent French President Emmanuel Macron secured another five-year term. His re-election supports further EU integration, but he is also facing increasing economic and political headwinds. With only 59% of voters endorsing him for a second term, he has to govern a divided country and the weaker mandate could make it challenging to push ahead ambitious reforms of the pension, health, and education systems. To what degree Macron can implement his plans will depend on parliamentary elections held in June.

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