The global growth outlook has evolved into an ugly contest. Following the fallout from the war in Ukraine, Europe is almost certain to suffer a deeper recession than the US.
The UK economy also appears particularly vulnerable due to its strong trade ties with Europe and a more general dependence on imported power and electricity.
Despite this, interest rates in both the Euro area (EA) and the UK are likely to end up a lot higher than might have been expected for economies with low neutral policy and potential growth rates.
This past week, the markets may have caught on to this outlook. UK gilt yields rose dramatically despite the Bank of England’s (BoE’s) less aggressive than expected rate hike – the BoE hiked 50 basis points (bps) vs. 68 bps that was priced into the market before Thursday’s announcement.
Indeed, the yield on the 10-year UK gilt at 3.8% at the time of this writing is at its highest level since 2011. Similarly, German bund yields also rose, with the 10-year bund at 2.1% – the highest level since 2013 – although not as dramatically as in the UK.
Perhaps more interestingly, in the face of a worsening inflation outlook in the US and the Federal Reserve’s substantial upward revision to its outlook for the overnight policy rate, both EA and UK government interest rates rose at a faster rate than similar rates in the US.
We see several reasons why the Euro area and UK economies are likely to experience much higher rates relative to their own histories and potentially on par with the US.
High energy prices the top priority
First, in contrast to the US, European and UK fiscal policies continue to be expansionary and prone to ease further.
Efforts to cushion the impact of higher energy prices on consumers and businesses have become the top political priority for these governments. In the UK, a large fiscal package was just announced and is expected to pass Parliament.
Among other things, it cuts taxes across the board and caps energy costs for households, amounting to roughly 4%–5% of GDP in the first year alone.
Meanwhile, the EA has also moved to expand government spending in the form of fiscal transfers and subsidies in an effort to blunt the negative effects on discretionary incomes of higher energy costs, although to be sure, the aggregate amounts are nowhere near the size what is being proposed in the UK.
Demand-boosting fiscal stimulus appears problematic in the face of the supply constraints faced by these economies.
The UK’s policy to cap energy prices should help mitigate the powerful incentive that higher prices provide to conserve energy.
Furthermore, fiscal stimulus in the face of already tight labor markets in the UK and EA means that monetary and fiscal policies are essentially working at cross purposes: More restrictive monetary policy will likely have to compensate for the additional fiscal stimulus.
Second, because the cause of inflation in Europe is much more a function of supply shocks to energy and food as it is contracting demand, a recession of similar magnitude will likely have less of an impact on spot inflation than in the US.
Accordingly, reducing spot inflation in the EA and the UK likely necessitates a restrictive monetary policy stance despite the outlook for recession.
Bringing workers back to the job market
Third, achieving short-run labor supply gains appears less likely in the EA. With the EA participation rate near all-time highs, we believe a cost-of-living recession in Europe is less likely to bring workers back to the job market.
To be sure, accelerating inflation across developed economies raises incentives to seek employment, since it raises the real opportunity cost of not working.
Still, scope for the potential realization of these labor supply benefits appears best in the US, where labor force participation rates, including the so-called prime age rate (participation of 25- to 55-year-olds) is still below pre-pandemic levels.
Finally, and maybe most importantly, despite slowing domestic demand, high energy prices have undermined the Euro area’s current account surplus while pushing the UK’s structural deficit to all-time highs.
The trade-weighted US dollar has appreciated by 9% in 2022, as of this writing. In contrast, the euro and pound sterling have depreciated by 12% and 16%, respectively.
This provides an additional inflationary tailwind that the European Central Bank (ECB) and Bank of England need to tackle.
More concerning, it also sets the stage for developed market central banks to get stuck in a competitive tightening cycle, where synchronized self-fulfilling interest rate increases only stop when it becomes clear that the global economy has suffered from aggregate tightening that has a far larger impact than the sum of the parts.
Soft or hard landing?
Simply put, it is much harder to engineer a soft landing if potential supply has been destroyed or is no longer responsive to higher prices.
The ECB and the BoE seem to have little choice but to compound the negative energy supply shock to output with even more demand destruction. Of course, the job becomes harder in the face of additional fiscal stimulus and depreciating currencies.
And this, centrally, is why monetary policy may end up being much more restrictive in the UK and EA than in the US.
In a pre-pandemic world of great abundance, supply was rarely a constraining factor on growth or a driver of higher inflation. Now, in the wake of a pandemic and war, supply constraints have not only become a material driver of inflation but also a major differentiator across countries.
While Europe will almost certainly suffer a more severe growth shock than that of the US, it is quite possible that the destination for monetary policies, and in turn interest rates, is similar in absolute terms. Where it’s the supply that binds, the old rules of monetary policy may no longer apply.
Tiffany Wilding is North American economist at PIMCO.