Europe | No respite for inflation

Some games seem pretty much decided before the final whistle. Something similar is happening with European inflation. The Eurozone had managed to bring it back down to around 2% without causing a recession, but the war in Iran caught the ECB off guard just as it was completing its soft landing.

The July data is a reminder that the game is still wide open. Headline inflation rose to 2.9%, up from 1.9% in February before the conflict. Energy accounted for much of the rebound, although core inflation also accelerated to 2.5%, with services remaining above 3%. We are not seeing an unanchoring of inflation expectations, but there are signs that higher energy costs are beginning to spread beyond just fuel. Nevertheless, this data should be interpreted with caution due to summer seasonal effects.

The reaction of the energy markets remains more muted than expected. The closure of the Strait of Hormuz disrupted about a fifth of global oil supply, but prices have risen much less than historical experience would suggest. The market entered the conflict with an oversupply, higher inventories, and more flexible Asian demand. China had built up reserves, and the coordinated release of strategic stocks provided an additional cushion.

A similar situation is unfolding with natural gas. Europe is starting from a less fragile position than in 2022 due to the diversification of its suppliers and a greater capacity for LNG imports. There has also been less Asian competition for cargoes, partly because some economies have substituted gas for coal in power generation. That flexibility has reduced the pressure on LNG and kept European prices in check.

Regardless, these buffers are not infinite. The (failed) truce provided a breather, but the new escalation comes with less margin for error. If the partial closure of Hormuz drags on, commercial and strategic reserves will approach critical levels, and the market will stop counting on a quick resolution. That is where the non-linearities of the shock could appear. Prices would no longer react gradually, bottlenecks would emerge, and the impact on gas and electricity would be greater as Europe rebuilds its stockpiles ahead of winter.

It is also important to distinguish what kind of inflation the conflict is generating. Business surveys primarily point to a supply shock. Companies are talking about energy and production costs, not overwhelming demand. In 2022, the post-pandemic reopening went hand-in-hand with global bottlenecks and stronger demand. This difference is key for the ECB. Cost-push inflation does not require the same monetary policy tightening as demand-pull inflation. Raising interest rates will neither reopen Hormuz nor produce more oil.

Just because the origin is external doesn't mean the ECB can ignore it. Transmission happens in stages. First comes the direct effect on fuel and electricity; then, the indirect effect on transportation, imported goods, and energy-intensive sectors; and finally, the second-round effects, when companies and workers bake inflation into prices and wages.

Another difference from 2022 is the labor market, which is currently less tight. Job vacancies and hiring expectations have fallen, while demand is less dynamic. Surveys also do not show a worrying acceleration in wages. Short-term inflation expectations have ticked up, but long-term expectations remain anchored. This reduces the risk of a wage-price spiral and points to a less aggressive response from the ECB. Even so, these effects usually appear six to twelve months after the shock. The absence of clear signals right now is not definitive.

Food adds another risk, albeit a more delayed one. Food inflation remains contained for the moment, but it takes time for energy and fertilizer costs to pass through to final prices. Compounding this are increasingly adverse weather conditions, including heatwaves, droughts, low river levels in Europe, and a potentially severe El Niño event, the effects of which would be highly uneven among major agricultural producers.

Europe continues to be better prepared than in 2022; however, we are heading into uncharted territory if the conflict in Iran is not resolved soon. The longer it lasts, the more likely it is that buffers will run out and the shock will ripple through the rest of the economy.