Food and energy prices are rising! Is global inflation making a comeback?

If food and energy inflation were to make a comeback, what will happen to the already cooling inflation in the Eurozone? Will the "hawkish" stance of the European Central Bank continue?

In their latest report, a team led by Nomura's Chief Economist Rob Subbaraman pointed out that the upward risks to inflation in most economies have increased, given the recent rise in energy and food prices. Currently, the inflation rates in most countries are still far above the target level. However, if the surge in commodity prices is driven by supply rather than demand, it could lead to more severe stagflation consequences:

The increase in commodity prices will not only exacerbate the rise in CPI but also weaken economic growth. In the absence of increased demand, rising food and energy prices will erode household purchasing power and corporate profits.

The most vulnerable are net commodity-importing countries and/or low-income economies, where food constitutes the largest share of the consumption basket.

For these fragile economies, intensified inflation along with weak economic growth may also be accompanied by deteriorating trade (higher import costs) and fiscal conditions.

In extreme cases, further deterioration of economic fundamentals can trigger a vicious cycle - rising inflation, capital outflows, and currency depreciation forcing central banks to significantly raise interest rates, thereby further weakening economic growth.

Nomura points out that from the chart above, it can be seen that since June 30th of this year, prices of food and energy have generally been on the rise, and these price increases appear to be more supply-driven. Assuming a 20% increase in food and energy prices by the end of the year, most central banks, except for the Bank of Japan, will eventually maintain interest rates at higher levels for a longer period of time. In Europe, Italy and Spain will be the most vulnerable.

Will supply-driven inflation make a comeback?

In July, the overall CPI in the United States rose while the core CPI fell, resulting in the smallest consecutive MoM increase in core CPI in over two years. This has further fueled market optimism. The Eurozone's harmonized CPI for July had an initial YoY value of 5.3%, down from the previous month's 5.5%, indicating a slowdown. The market is betting that there is a 75% chance of the ECB pausing rate hikes in September.

However, the recent surge in food and energy prices may make it difficult for overall inflation to decline in Europe and the United States. If consumers raise their expectations of future inflation, it could further impact core inflation.

Recently, news of tightening oil market supply has driven international oil prices to continue rising. As of Friday, August 11th, international oil prices have recorded seven consecutive weeks of increases, marking the longest continuous rise since 2022.

According to the latest monthly report from OPEC, it is predicted that oil demand will continue to grow for the next two years. There may be a huge supply gap of over 2 million barrels per day this quarter, and global oil demand is expected to increase by 2.44 million barrels per day this year. The organization stated that the outlook for the oil market in the second half of this year looks "very healthy".

Nomura stated in its report that US oil demand is soaring, commercial flight numbers are reaching historic highs, and the increase in temperature is leading to higher usage of air conditioning and power grids, which could further drive up energy prices.

Similarly, the natural gas market has also been turbulent recently, with strikes at Australian natural gas plants posing a threat and sounding the energy alarm in Europe. Bond traders are concerned that the European Central Bank will take a more hawkish stance.

According to an article by Bloomberg on Sunday, ING, Rabobank, and ABN Amro Bank predict that as energy prices rise again, the European Central Bank will shift to a hawkish stance and officials will prevent long-term inflation expectations from rising.

Benjamin Schroeder, Senior Interest Rate Strategist at ING, said:

Suddenly, the inflation alarm is sounding again. The recent volatility in natural gas prices highlights the ongoing risk of supply disruptions to the relatively moderate inflation dynamics in the near term.

In addition to energy supply, escalating geopolitical conflicts combined with the El Niño effect may impact global food supply, causing food prices to soar.

On July 17th, Russia announced its withdrawal from the Black Sea Grain Agreement. This agreement allows cargo ships to pass through specific channels in the Black Sea, transporting grains safely to and from Ukrainian ports for export worldwide.

At the end of July, the Chief Economist of the International Monetary Fund (IMF) stated that the restriction of grain trade caused by geopolitical crises will greatly impact global food supply, and wheat prices may rise by more than 15%.

Under the influence of the El Niño phenomenon, rice and sugar production in India have been damaged. As the world's largest exporter of rice, India has decided to ban most rice exports in order to ensure domestic food supply and stabilize domestic food prices. Market concerns arise that the Indian government may extend its reach to sugar.

Due to insufficient rainfall, the Thai government has reduced rice cultivation to conserve water. Since June, the price of Thai rice has soared by 25%, reaching the highest level since 2008. Nomura believes that food protectionism may be reasonable for a single country, but if several countries take similar protectionist actions in succession, it may inadvertently exacerbate the upward risks in global food prices, as was the case in 2007-2008 and 2010-2011.

The economic impact on various countries in Europe and America?

Nomura Securities believes that the surge in commodity prices generally has a relatively small negative impact on the German economy, but the high CPI in Germany cannot be ignored. The most worrying aspect is the negative impact of rising food and energy prices on Italy and Spain. The Federal Reserve will pay more attention to inflation expectations surveys, which will be an important factor in driving up core inflation.

To assess the economic impact and possible policy measures by central banks in various countries, Nomura made the following assumption: by the end of the year, food and energy prices will rise by 20% compared to the level in early August (for example, this would bring Brent crude oil prices to around $100 per barrel):

From the perspective of the United States, a 20% increase in energy and food commodity prices could lead to a significant acceleration in overall CPI inflation in the United States.

In the overall Consumer Price Index in the United States, household food prices consist of groceries and energy prices, accounting for 4.8% and 7.0% of the Consumer Price Index, respectively.

Specifically, compared with the prices of commodities, the downward rigidity of food retail prices seems to be higher, and there is a lag in the impact of commodity price changes on food retail prices. Despite this uncertainty, a continuous 20% increase in energy and food commodity prices could still potentially push up overall CPI in the United States by 2 percentage points.

From the perspective of the Federal Reserve, we believe that the FOMC may overlook the overall CPI increase driven by commodity prices because core inflation (excluding food and energy components) historically provides a better prediction of future inflation.

However, considering the importance of public perception of inflation in dynamic inflation data, the rise in prices of essential goods may increase consumers' inflation expectations, thereby leading to an increase in inflation.

Nomura points out that according to the New York Fed's consumer expectation survey, the median of the three-year inflation expectations seems to be influenced by consumers' views on food and energy prices rather than rent or medical service prices. Similarly, the 5-10 year inflation expectations from the University of Michigan seem to be sensitive to gasoline prices, and higher inflation expectations may affect core inflation through wage negotiations or increased pricing power for businesses:

We believe that the Federal Reserve will pay closer attention to inflation expectations surveys, as this is a factor that could drive up core inflation due to the surge in commodity prices.

For Europe, Nomura found that in Belgium, Spain, and Italy, food and energy prices account for a higher proportion in the HICP basket, while in the UK, Austria, and Germany, food and energy prices account for a lower proportion in the HICP basket (the proportion of food in the HICP basket is highly positively correlated with the proportion of energy in the HICP basket).

Considering the risks consumers face in terms of food and energy, as well as the potential impact of extreme weather events on production, Nomura states that the most worrying aspect is the negative impact of rising food and energy prices on Italy and Spain. France, Germany, and the UK are in a better situation, but among these countries, France may be the most stable because of its lower dependence on fossil fuels in its energy structure.

Energy and food prices rising by 20% may not necessarily trigger a fiscal response similar to last year's surge in natural gas prices.

At the same time, monetary policy has already tightened significantly, making further aggressive rate hikes seem unlikely. Nevertheless, in the process of reducing inflation, the renewed increase in commodity prices suggests that interest rates need to be maintained at a higher level for a longer period of time.

As Huw Pil, Chief Economist of the Bank of England, recently stated in a speech, the central bank "will respond to this." Therefore, if the tightening monetary policy significantly suppresses consumption and economic activity, the risk of the entire Europe entering a recession will be higher.