Markets are currently focused primarily on energy prices and interest rates
At the moment, the markets are reacting primarily to trends in energy prices and interest rates. In previous reports, we noted that economies, particularly that of the U.S., are being driven by the boom in AI-related investments and by the large government deficit. This means that if energy and food prices continue to rise as a result of the situation in the Middle East, this will soon lead to higher inflation. Western economies are already operating at high capacity utilization, so strong growth coupled with rising energy and food prices will soon lead to so-called secondary effects. This means that the prices of all sorts of other products will increase because they consume a lot of energy and/or food. In addition, upward pressure on inflation could also drive up wage increases.
In this regard, the markets are drawing a great deal of hope from the expectation that China, Europe, and the U.S. would benefit from a drop in oil prices. It is therefore quite possible that they might reach an agreement among themselves to drive the price down. However, it is not that simple. China, in fact, has very large oil reserves and refineries. As a result, it can still cope with high energy prices for quite some time, at least much better than Europe. This applies much less to the U.S., as the country is largely self-sufficient in energy. Yet the U.S. also has a significant Achilles' heel: Trump and the Republicans are under immense pressure on the eve of the midterm elections. It is therefore quite possible that China will not cooperate, for the time being, in a joint effort to drive down oil prices. For the same reasons, Tehran will also stand its ground for the time being.
In addition, the weakness of the U.S. is becoming increasingly apparent. In principle, the U.S. is militarily much stronger than any other country, certainly compared to Iran. Yet the U.S. did not come to Saudi Arabia's aid when that country was attacked by the Houthis. In the opinion of many experts, this is because the conflict could easily escalate, and the U.S. no longer has the ammunition to handle it. In Tehran, this will certainly be seen as an opportunity to go quite far (Beijing may also view it this way with regard to Taiwan). There is another factor to consider: if China and/or Iran succeed in defeating Trump and the Republicans in the midterms, Trump's position will be severely undermined. In other words, Trump is currently doing all sorts of things that actually require congressional approval, but he has such a firm grip on Congress that it rarely poses an obstacle for him. However, the situation will look entirely different if the Republicans lose their majority in Congress. The new Congress and the president will then often find themselves at odds with one another. The end result will be a high degree of indecision, something that would suit Beijing and Tehran very well.
In short, there are all sorts of reasons why oil prices might fall, but we'll have to wait and see if that actually happens. For now, we're seeing oil prices rise rather than fall. This brings us to interest rates. If oil prices do fall, that will pull inflation and interest rates down with them. The question, however, is by how much: lower energy prices, inflation, and interest rates actually fuel economic growth, which in turn puts upward pressure on interest rates.
Reactions from the central banks
If inflation remains high or continues to rise, the ECB and the Fed will have to adopt a somewhat restrictive monetary policy. The Fed will need to do so to a greater extent than the ECB, because:
- the U.S. economy is growing faster, which means secondary effects are more likely to occur;
- higher energy and food prices are slowing down the European economy more than the U.S. economy;
- the U.S. economy receives relatively more fiscal stimulus, and there is also relatively much more investment in everything related to AI in the U.S.
Read here how the Fed and the ECB should respond to this
The key question now is how the Fed and the ECB will respond to all of this. Recently, both the U.S. and Europe have reported stronger-than-expected economic data. With oil and food prices still high, this creates a clear risk of inflation. How will both central banks handle this?
Let's start with the Fed. The U.S. central bank must weigh the following factors against one another:
- Many economists feared that the U.S. economy would slow down significantly due to reduced consumer purchasing power resulting from high energy and food prices, as well as rising interest rates. Recent figures, however, suggest the opposite.
This situation argues in favor of the Fed continuing to raise interest rates until growth falls back below "potential growth." It is important to note, however, that for now the threat of inflation is not so great that it necessitates steering the economy toward a recession. This would only become the case if inflation were to climb significantly higher.
For now, therefore, reducing growth to around 2% appears sufficient. In practical terms, this likely means short-term interest rates will rise by about 1 percentage point (slightly more than the market is already pricing in).
- At the same time, however, the Fed must be cautious about raising interest rates. First and foremost, because another scenario is quite possible: if the Strait of Hormuz reopens and oil and food prices subsequently drop sharply. In that case, the inflation risk would be manageable for the time being, although higher growth, and thus tightening of the labor market, would likely follow. At a slightly later stage, higher wage increases could still force the Fed to adopt a tighter monetary policy, though less tight than in the case of rising commodity prices.
Equally important, however, is the following. The massive investments in AI are currently contributing to strong economic growth and upward pressure on all kinds of prices. In about a year, however, all these investments will lead to a tremendous increase in the supply of AI and, consequently, to higher productivity growth. The economy will then be able to grow faster without inflation rising. It cannot be ruled out that we may even face deflation again.
Since rate hikes take effect in the economy only after a lag of about four quarters, this is something to keep in mind to some extent right now. This, too, argues in favor of not going any further for the time being than reducing U.S. economic growth to about 2%. Depending on the extent of the increase in productivity, the appropriate monetary policy can then be reassessed later.
The same applies to the ECB, albeit to a lesser extent. In Europe, economic growth is not (significantly) above "potential growth," and higher energy and food prices are putting a much greater brake on economic growth.
In addition, there is less investment in AI in Europe, a factor that could eventually lead to lower productivity growth than in the U.S. It is therefore not the case that the ECB can afford to do nothing. It simply needs to do less than the Fed does.
