The energy explosion will surely plunge Europe into recession. Interest rates will have to rise there too, but the sources of domestic inflation are not as important as in the United States.
Fed Chairman Jerome Powell made it clear at the Jackson Hole meeting last week that he would continue to raise interest rates until inflation was clearly under control. By contrast, markets had already priced a U-turn in the Fed for next spring, with significantly lower interest rates through the end of 2023. After Powell’s speech – and comments from other members of the rate committee – the markets expect a more rapid tightening in the coming months then only a moderate decline in rates. The Fed also acknowledged that the unemployment rate would need to rise to contain inflation. In my view, a real recession is needed.
Inflation in Europe is high and continues to rise, mainly driven by food and energy prices. Gas prices were multiplied by 20 – or 2,000% – following the reduction in Russian deliveries. The explosion in energy costs will surely plunge Europe into recession. Interest rates will have to rise there too, but domestic sources of inflation – wages and rents – are nowhere near as important as in the United States.
Let’s now take a look at Great Britain. If Liz Truss becomes the next prime minister, as widely predicted, she could respond to the cost of living crisis with an exceptional plan. The plan calls for a freeze on energy prices through a state fund, which would lend money to energy companies. The loans would be repaid when the gas price falls. This would result in lower inflation, a lower premium on index-linked government bonds, a reduction in social security contributions and a higher personal income. It would even avoid a recession. The plan, however, would require huge and unlimited subsidies and would depend on a sharp drop in gas prices. It would therefore be a high-risk, high-return strategy.
The context is therefore extremely worrying for Britain in general and for the pound in particular. After the surprising increase in inflation in Britain two weeks ago, expectations of a future increase in bank interest rates have increased. These should normally lead to an inflow of capital and strengthen the British pound, but the currency has not been able to recover. Several economists have pointed out that this is the kind of reaction that can be observed in an emerging country. I think it is excessive. But as the current account deficit approaches 5% of GDP and gas prices soar, there is a real risk that the British pound will collapse against a strong US dollar. The all-time low was US $ 1.05 in February 1985, just above par. We could revisit this level.
All in all, this is bad news for risky investments. I expect stock prices to go down.