Sticky Inflation is Back – Euro Inflation Surge Looks Great for Gold

Sticky inflation is making headlines again, this time the European Central Bank’s (ECBs) battle with a recent surprise continued surge in inflation in the Eurozone to 8.5%, only marginally down from 8.6% in January. Nearly all of this drop is from moderating energy prices.  ‘Sticky inflation’ has been identified in the ECBs February meeting minutes as the major culprit with Core CPI surging 5.6% and well above the 5.3% expectation. “Core inflation and other measures of underlying inflation were likely to be stickier, with only limited evidence of a stabilization so far”. 

History of sticky

Sticky is now a general economic term used to describe a financial variable that is resistant to change, it appears to be growing in acceptance to describe our current inflation situation.   The term was coined by Maynard Keynes, in his nominal rigidity of wages.  Prices can become sticky due to the asymmetry in the market whereby something may move easily up but not easily down (sticky down). 

So as the theory goes wages tend to respond slowly to economic and company performance.  When unemployment rises wages stay stable or rise slowly but don’t go down.  This therefore means they can go up easily but not down – responding positively to positive forces (such as the recent low unemployment) but resist forces pushing them down, and therefore pay cuts.  Economists theorise that wage stickiness is an illusion, as if there is stickiness in one market, ie wages, real income will be reduced as a result of wage spillover into cost of goods and therefore inflation. This is known as wage-push inflation and resembles a lot of what we are currently seeing.

Interestingly when identified, Keynes believed that in a disequilibrium such as we are currently seeing and as was apparent in the 1930s, the federal government needed to implement fiscal policies to assist with readjusting the equilibrium.

Sticky making the headlines again

The aforementioned strong Eurozone inflation now means that, in the short term, the ECB is likely to raise interest rates 50Bp in March and the markets are now pricing another 50Bp rise in May.  JPMorgan economist Greg Fuzesi has upgraded their view on rate hikes from 25Bp to 50Bp, taking their ECB terminal rate forecast to 3.75% in June.

Just like in other parts of the world, the ECB policymakers have identified the labour markets as being very tight and likely to fuel these inflation pressures.  Many firms in Europe are still complaining about labour shortages and the unemployment rate remains tight at 6.7% (the record low for the ECB is 6.6%). 

On top of this as Isabel Schnabbel, and ECB board member stated, inflation may be more persistent than estimated, as there was still far too much cash remaining in the banking system after some 7 trillion euros have been put into the system since the GFC.

Why is Inflation Sticky?

Menu cost theory is a theory that says when a firm sets a new price for their goods there is a cost in doing so.  Hiring of sales people to push costs through, changes in marketing and revised input/output costs. So in the last 12 months as firms look to change their ‘menu costs’, the pricing of goods (a major culprit in the current inflation), these firms have had to deal with low unemployment and the inability to find staff as well as several other shocks including, Ukraine Energy Shock, Global climate shocks (flooding, droughts), China’s Lockdown and supply chain shocks, so it is reasonable to conclude that firms looked to price in these uncertainties, which has created possibly an overshoot in their pricing models. 

As energy prices moderate, supply chains ease up, China’s lockdown ends and the wage spirals feared appear to be less dramatic than anticipated, these Menu changes should be feeding through.  But we’d suggest with the current Global political environment, firms are unwilling to pass these reductions through due to the high uncertainty risk.  This is creating a sticky inflation situation where prices are not receding.

In fact if you look at the monetary mechanisms trying to control this inflation it could be argued particularly in Europe and the US with long term fixed mortgages, that the impact on the consumer is minimal, but adding cost to firms who are feeding this through in pricing.  Monetary policy is used to lift unemployment and curb demand, but in a state of full employment and low participation rates the ability of the employment market to expand with increased wages is tempering this mechanism. Whilst this happens the cost of capital to firms increases and this is fed through in Menu pricing.

Euro Strength, Sticky Inflation, Commodities and Gold

Looking at commodities and precious metals, under this ‘sticky’ scenario and its current resilience against what has been a rising USD, this should be very constructive. The higher Euro on rising rates should see a weaker USD. That weakness in the DXY (USD index), from the strength of the Euro will assist gold in rising in the short to medium term as the inflation problem moves away from the US to Europe.  A recent prediction from Jeff Currie, global head of commodities research at Goldman Sachs believes commodity prices will soar 43% this year.  The Aussie currency due to the rate differential is unlikely to keep pace this time with gold, making Aussie gold a more compelling….