Another Money Magic Tree Dries Up

Key points:

• We explore the risk of a protracted cut in Russian gas supply after the “maintenance period”.
• Fed hawks bolstered by the latest labour market data.
• That inflation helps with public finance is not a “law of the universe”. Europe is not experiencing “the right kind of price shock” from that point of view.

The beginning of a “maintenance period”, which is stopping the flow of Russian gas to Europe via Nord stream for 10 days, is focusing attention on the risk of a more protracted Russian embargo which could tip in the Euro area into a recession. A key issue is whether a comprehensive European solidarity mechanism pooling scare gas resources could be conjured up to support Germany and Italy. The current system designed by the European Union (EU) rests on a series of bilateral agreements which would be insufficient. We could easily picture a complicated “give and take” negotiation to get a stronger framework across the line, with France and peripherals arguing that the natural “complement” to such solidarity in the realm of energy supply benefiting Germany would be another push towards debt mutualization – the second stage of Next Generation EU (NGEU) which has so far been elusive. This would not be an easy discussion.

“Gas stress” is in any case pushing prices further up, jeopardizing the gradual deceleration in headline inflation which base effects would provide. In the US, “persistent inflation” is more likely to come from a lack of sensitivity of the labour market to the economic slowdown. From that point of view, the stronger-than-expected job creations in June unveiled last week strengthened the case of those at the Federal Open Market Committee (FOMC) who argue for another 75-bps hike.

The only benefit of inflation is its capacity to help with reducing public deficit and debt, as long as real interest rates don’t react too much. However, it is not a “law of the universe”. Drawing on Agnes Benassy-Quéré’s latest note we distinguish two cases. One when an economy is faced with overheating, and the GDP deflator rises in sync with consumer prices (close to the US current situation), and another where an exogenous shock dominates, and consumer prices rise much more than the GDP deflator (European situation). It is much harder to bring public debt back under control in the second case. While the current fiscal mitigation of the price shock is justified, it is not a “free lunch”. Painful decisions will have to follow.