Done With Orban

by Maartje Wijffelaars, Senior Economist at Rabobank

As widely expected, the Bank of England kept its Bank rate unchanged yesterday, at 5.25%. Just like the US Fed did on Wednesday and the ECB last week. The main difference was, however, that in the UK the votes were not unanimous: two members voted in favour of a hike, one for a cut, and six to keep the rate unchanged. The MPC reiterated that it remains prepared to adjust monetary policy as warranted by economic data to return inflation to the 2% target sustainably, but dropped the warning that more hikes may be needed to get there. So despite the votes in favour of a hike, the BoE adopted a more dovish tone.

Looking ahead, our UK strategist Stefan Koopman expects the BoE to keep its policy rate on hold until September, after which it will start a gradual cutting cycle. This is later than the market is pricing for. It also means we expect the BoE to start cutting in the same month as the ECB (September), yet later than the Fed (June). Together with current market pricing and the UK economy performing better recently than the Eurozone, this informs our view that there is scope for EUR/GBP to edge lower to the 0.84 level on a 6-month view.

Indeed, January’s PMI surveys suggest that activity in the Eurozone contracted at the start of the year (composite PMI at 47.9), while the UK economy started on a relatively good footing (PMI composite at 52.5). So while we still foresee significant structural economic weakness for the UK, in the short term it could well outperform the currency block. This is largely due to weakness in Germany (composite PMI at 47.1), while French surveys (composite PMI at 44.2) also paint a gloomy picture. Germany was also the weakest performer among large member states last year, with its economy falling 0.3% q/q in 23Q4.

For the Eurozone overall, 2023’s ending was like a party without cake. It managed to avert a forecasted contraction, and hence a recession, yet stagnation is as good as it got, against the backdrop of a significant increase in interest rates since mid-2022.

Going forward, recent survey data suggests that the downturn is bottoming out, but weakness certainly persists. Although we believe that consumer spending growth should start to recover over the course of 2024, there is more uncertainty when it comes to investment activity. In a publication published earlier this week we zoom in on investments, looking at recent developments and the outlook. In short, we expect investment growth to recover moderately over the coming quarters, even though past rate hikes are still working their way through the economy and self-financing capacity of firms has reduced. Drivers are a significant drop in capital market rates over the past months, untapped potential in the Recovery and Resilience Facility, and last but certainly not least, strategic motivations.

Somewhat stronger economic figures than expected – especially in Southern Europe – combined with January’s inflation figures, support our view that the ECB will wait a bit longer to start cutting than the market currently expects.

Inflation continued on its downward path in January, but published figures underscore our view that the last mile is the longest. Headline inflation dropped from 2.9% y/y in December to 2.8% y/y in January, which is higher than consensus of 2.7% and our own estimate of 2.6%. Core inflation dropped from 3.4% y/y in December to 3.3% y/y in January, slightly higher than the consensus of 3.2% y/y but in line with our in-house projection.

While we foresee a further decline over the coming months, we think that the tight labour market and indications that wage growth is likely to stay elevated this year, make further progress towards target rather slow. We forecast inflation of 2.7% in 2024 and 2.7% in 2025.

The main risk to our outlook comes from the trade disruptions in the Red Sea, a theme discussed more than often in this Global Daily. The Red Sea trade disruptions has caused shipping prices for containers from China to Europe to quintuple. Manufacturers are also already signalling that the disruptions are causing delivery delays and that the higher costs are beginning to feed through here and there. For the time being, however, there is still little evidence that trade disruptions in the Red Sea will result in a significant inflationary shock. Freight rates account for less than 1% of the final cost of manufacturing output, demand is weak, and while energy prices have increased over the past weeks, they are still below autumn’s peak – let alone the peaks witnessed in 2022.

Yet, the experience of 2021-22 shows that this is not a sufficient condition for stability! To the contrary, if trade disruptions spread, the inflationary effects may be greater if companies face a shortage of inputs. Moreover, while overall logistics account for a limited share in final output costs, price increases and disruptions to flows of certain goods can have a much larger impact on inflation than they would have on average. Take diesel for example. Due to relatively much weaker availability of fuel tankers than container vessels, problematic disruptions to the inflow of diesel could well come faster than to the import of consumer goods or inputs thereof. This is especially given the already historically low diesel inventories and weak refinery capacity on the continent – contrary to still adequately perceived stocks of inputs and finished goods. Moreover, the fact that diesel is required for logistics, from trucks to tractors, disruptions in the flow of diesel could be especially problematic and cause non-linear effects.

Given the uncertain second and third order effects, it is difficult to predict how large the inflationary effects will be. A new bout of inflation, as we saw in 2021-22, however, would require a shortage of inputs to be accompanied by a sharp rise in energy prices, whilst demand would have to remain relatively strong for companies to increase their prices. For now we expect the crisis in the Red Sea to slow or delay disinflation rather than fuel a strong increase in inflation. But it will also largely come down to how long it will take to solve the crisis. This is by no means straightforward. And clearly, the repercussions would be much worse if disruptions would spread to the Strait of Hormuz. Importantly, it means the task of the ECB hasn’t become any easier.

In other news, yesterday the EU27 finally agreed on a new four-year EUR 50bn support package for Ukraine. This was despite farmers fed up with EU rules tried their best to block the entry of the council building. The new support package had previously been vetoed by Hungary’s Orbán, in an attempt to unlock EUR 30bn funds held up by Brussels. In December, Orbán managed to obtain EUR 10bn previously frozen EU support money, but he wanted all. It had already become clear that Brussels was done with Orbán. Earlier this week the idea of a plan to destroy the Hungarian economy if it didn’t lift its veto was conveniently leaked to the FT – the leak already led to financial market turmoil and a backlash at home. Now it’s unclear what exactly did the trick, but according to Politico, a small group of leaders managed to convince Orbán in a backdoor meeting to agree. This is much welcome for now. But the saga, again, shows that the EU should reform its governance, such that a single country cannot hold the entire Union hostage.