Against the spectre of soaring energy prices, labour shortages and supply chain constraints, a question that has arisen in the US has landed firmly on European shores: will inflation continue to rise and how persistent will it be?

The prevailing school of thought is that inflationary pressures will peter out once economies are past the post-COVID recovery and Europe will return to its decade-old pattern of low growth, low inflation and low interest rates. My view is that the pandemic has brought about changes in consumer behaviour and the political climate that, when combined with secular shifts that were already underway, will likely result in a shift to higher inflation in the range of 2% to 3% in Europe over the next few years. I expect eurozone real gross domestic product to increase to around 5% in 2021 and 4.5% in 2022, with the UK economy growing by around 7% in 2021 and 5% in 2022.

Eurozone inflation has recently climber above its medium-term target of 2%¹

Interest rates could shift moderately higher, but that will depend largely on the reaction of the European Central Bank (ECB) and the Bank of England (BOE). The ECB has held its main refinancing operations rate at zero since March 2016 and does not seem likely to raise rates in the foreseeable future. It did, however, begin slowing the pace at which it is buying bonds through its Pandemic Emergency Purchase Programme (PEPP) in September. It is likely to let the program expire in March 2022. The BOE cut its benchmark bank rate to 0.1% in March 2020. Markets are pricing in an expected rate hike of approximately 0.25% by the end of the year, with more hikes in 2022.

Central bank benchmark rates and market expectations²

Here are six reasons why I expect to see higher inflation and faster growth in Europe over the next few years:

1. Structural shifts in energy will keep prices higher

Industry is booming in Germany and the UK, so there has been a rise in demand for energy. At the same time, both cyclical and structural factors have lowered supply.

For natural gas, Europe is dependent on Russia and Norway, where there have been significant outages. That is partly due to politics and partly due to infrastructure, in terms of just not being able to get the gas into the rest of Europe. The shortages are also related to the fact that last winter was actually quite cold and thus Europe didn't build up any gas stocks.

This combination of very strong demand and low reserves has been made worse by the slow pace of transition to renewable energy. Europe is still too reliant on fossil fuels. Wind and hydroelectric plants, for all kinds of reasons, haven't been producing enough electricity to meet base requirements. Europe needs to build out much more renewable energy capacity, which is going to take some time. And that means this supply problem is likely to be present for years to come.

 

1. Source: European Central Bank. Annualized quarterly data as of October 15, 2021.

2. Source: Bloomberg. Data as of October 15, 2021. The futures implied rate reflects market expectations for rate changes for December 2021.

 

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