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Wednesday, December 6, 2023

The week that inflation was consolidated

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The events of February 24 have resolved a dispute: inflation is no longer temporary.

There are four reasons to expect increased inflationary pressures and a mitigating factor.

Energy values ​​

The first is energy prices, with both crude oil and gas prices rising to very high levels since the start of the war in Ukraine. With the sanctions now in place, the European Union will have to reduce gas imports from Russia. This means both a reduction in collective demand and a replacement of demand from elsewhere. To the extent that this cannot happen in the next 12 months or so, the European Union (EU) is still dependent on Russia, so it is inevitable that action will become a tool of retaliation. As long as these sanctions remain in place, the EU will be vulnerable and will face a correspondingly heavy energy bill.


Second, in the face of high inflation and the uncertainty caused by the war, the European Central Bank (ECB) must reconsider its plans. Markets were expecting the ECB to announce the end of its Asset Purchase Program (APP), paving the way for interest rate hikes by the end of the year. Given the current situation and how fast they are changing, I expect a real change in the messages that the ECB will send at the next meeting on 10 March.

The ECB's narrative until a few days ago was that high energy prices were also temporary and that it could not use monetary policy to deal with them anyway. The ECB must now accept that prices will remain high for a long time, but also be clear that its policies must continue to be expansionary to address the uncertainty caused by the war. So not only will there be higher prices for longer, but the ECB will help.

Public Expenditure

Third, fiscal policy will be expansive, albeit in a different way than during the pandemic. The two categories to look out for are military spending and supporting households to cope with the energy burden.

In 2016, only three EU countries met NATO's defense spending target of 2% of GDP. Preliminary estimates for 2021 show that eight EU countries are now expected to meet it. The German government has now announced that it will increase military spending to 100 billion euros to meet this obligation to NATO. This compares with the 1.53% spent in 2021 and represents an increase of half a percentage point of German GDP, which will be maintained in the long run. Other countries will certainly follow suit, increasing their military spending.

Fourth, in addition to military spending, fiscal policy will have to deal with very high energy prices. At the beginning of winter, all EU countries provided assistance to households. As energy prices continue to rise and put a heavy burden on the inflation basket, we can expect further support measures. Importantly, the risk of a second-round impact has always been linked to the duration of higher inflation. As inflation now sets in, the risk is real and immediate.

Then the real question is what will happen to the recovery. The effects of the fiscal stimulus to deal with the effects of the war will be limited by declining investment and entrenched inflation. The war in Ukraine is expected to delay any return to a convincing course of development.

Bruegel, deputy director of the Brussels-based think tank think tank. This text was published in English as an opinion column on the Bruegel Blog, and on the Blog of the Cyprus Economic Studies Society (https://cypruseconomicsociety.org/).

Source: politis.com.cy

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