Russian Curb On European Gas Fuels Inflation And Forces Interest-Rate Hikes

  • Market Overview
  • Editors Pick
  • ECB expected to go for 75 basis point increase this week
  • US jobs surge keeps pressure on Fed to dampen employment
  • New UK government faces challenges in inflation, recession, and energy

Investors are now expecting the European Central Bank to raise its rates by 75 basis points when the governing council meets this week, after eurozone inflation hit a record 9.1% and Russia has exposed its intention to leverage natural gas deliveries against EU sanctions.

Kremlin spokesman Dmitry Peskov said on Monday that Gazprom (MCX: GAZP ) would not resume gas flows in the Nord Stream 1 pipeline to Germany until the West lifted the sanctions imposed after Russia invaded Ukraine. Russia is still delivering gas to Europe through other pipelines, but the curbs are leading to sharp increases in energy prices. At this point, European officials have no illusions about Moscow’s intentions.

Though successive US administrations warned Europe about the dangers of relying on Russian gas, EU leaders chose appeasement and, led by longtime German Chancellor Angela Merkel, even pushed ahead with the construction of a second Russian pipeline under the Baltic, which has since been mothballed.

Now the ECB will be forced to go for a bigger rate hike than its surprise 50-basis-point hike in July as sharply increasing energy prices fuel record inflation and push policymakers into a more hawkish stance. The cost-of-living crisis is leading European governments to adopt expensive relief aid for consumers and businesses.

Joachim Nagel, head of Germany’s central bank and a leading voice on the ECB council, is coming into his own as the inflation report last week prompted him to call for a big rate hike in September and further interest rate increases in the months ahead.

The German member of the ECB executive board, Isabel Schnabel—not President Christine Lagarde or chief economist Philip Lane—took the message of ECB resolve to the Jackson Hole symposium in August, suggesting the hawkish Germans are in the ascendancy in determining ECB monetary policy. She said the eurozone central bank was willing to risk recession if necessary to tame inflation.

ECB policymakers are learning that forecasting models developed in quieter times are not that predictive in a world ravaged by a pandemic and Europe’s biggest armed conflict since World War 2.

Their counterparts at the US Federal Reserve are coming to similar conclusions. Investors are still digesting Fed Chairman Jerome Powell’s speech at Jackson Hole as he abandoned earlier notions of transitory inflation and a soft landing for the economy in a pivot to unrelenting monetary tightening to fight inflation.

The U.S. jobs report for August showed the economy adding 315,000 nonfarm jobs , a significant decline from July’s 526,000, but still a driver for inflation as labor shortages push wages higher. Fed policy will seek to dampen growth in employment short of an actual contraction in the economy, but policymakers will err on the side of caution if inflation rates remain high.

In the UK, the Conservative Party has chosen Foreign Secretary Liz Truss to replace Boris Johnson as party leader and prime minister. The announcement Monday that she had beaten former Chancellor of the Exchequer Rishi Sunak will be followed today with her formal appointment by Queen Elizabeth II and the presentation of her cabinet choices.

The UK faces many of the same inflation challenges as the EU, exacerbated by a raft of bad policy choices under Johnson’s uneven leadership. Truss has been mixed in her messaging about Bank of England's independence (and about most other things), so it remains to be seen how her government will handle things.

Tax cuts are the most immediate relief on her agenda, as economists forecast a recession beginning this year. Truss has also pledged to address sharp increases in energy prices and take steps to ensure future supplies.

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