End of Inflation in Sight

For two years now, large parts of the world have gotten to know what inflation really looks like. While isolated economic disaster zones like Venezuela and Zimbabwe have suffered inflation in the millions of percent, Europe, North America, and most of the rest of the industrialized world enjoyed four long decades of relative price stability. 

The experience of high inflation has been painful, partly because for most people the memories of high inflation are vague. Policy institutions, like our central banks and our legislatures who have ignored the possibility that excessive monetization of government spending could cause high inflation, are now ill-prepared to deal with it.

Fortunately, it looks like our current inflation episode is reaching its peak, and that from hereon we can expect inflation to slowly subside. 

This comes not a day too soon. Inflation does a lot of harm to an economy. It erodes paychecks and digs holes in our finances. It makes financial planning a nightmare by drastically shortening the horizons over which we can safely predict our finances. Businesses cancel investments, and households tighten their belts. Both measures cause a decline in macroeconomic activity.

Governments benefit from tax revenue that rises with higher prices, but that does not mean better public finances. Many tax-paid entitlement programs are price indexed, with spending rising automatically with higher inflation. 

Some forecasters appear to believe that inflation will persist for an extended period of time. I disagree, and if the signs of an inflation peak that I point to here are as strong as I believe they are, then Europe could be out of this inflation episode before next summer. 

The first good news is that North America has already reached its inflation peak point. Inflation in the U.S. economy topped at 9.1% in June. Canadian inflation reached its top of 8.1% in the same month. Since then, both countries have seen consumer-price inflation decline: the October numbers are 7.75% for the U.S. and 6.9% for Canada. 

Europe is not there yet, at least not as a whole, but individual EU member states exhibit signs of an inflation peak. 

Before we get to the details, let us just take a look at how quickly inflation conquered Europe. In December last year, only two countries had inflation rates in excess of 10%: Estonia and Lithuania. By March this year, seven other countries could boast of the same. In June, the 10+% inflation club had 15 members, and in September the number was up to 18. 

The weighted-average inflation for the European Union passed 10% in August. The euro zone narrowly escaped the 10% stigma, with a September inflation rate of 9.93%. Germany, the largest European economy, recorded an inflation rate of 10.9 % inflation in September. This was up from 8.8% in August and 8.5% in July. 

Lithuania is in even worse shape: at 22.5% in September, this Baltic state has had 20+ inflation since June, and it has been slowly ticking upward.

Figure 1 compares euro-zone inflation, from the beginning of 2016, to U.S. inflation, which includes October:

Figure 1

As of November 15th, a total of 17 EU member states had reported their inflation rates for October. Eight of them saw a rise in inflation from September, but the good news was that eight countries saw a drop in inflation. 

In Luxembourg, the inflation rate was unchanged. 

Inflation remains high, with Estonia leading at 22.4%, followed by Latvia at 21.8%, and the Netherlands at 16.8%. Of the 17 countries for which Eurostat has October numbers, France has the lowest inflation rate (7.1%), followed by Spain (7.3%), and Malta (7.5%). 

Inflation is still rising in:

• Austria: up from 10.9% in September to 11.5% in October;
• Belgium: from 12.1% to 13.1%;
• France: from 6.2% to 7.1%;
• Ireland: from 8.6% to 9.6%;
• Italy: from 9.4% to 12.8%;
• Malta: from 7.4% to 7.5%;
• Portugal: from 9.8% to 10.6%; and
• Slovakia: from 13.6% to 14.5%.
  

Among the countries with falling inflation, Estonia stands out with its 20+ inflation rate since May. In September, inflation was 24.1%, falling to 22.1% in October. While still very high, this is the first time since January, and only the second time in two years, that the Estonian inflation rate has declined.

Latvia has been right up there with Estonian and Lithuanian 20+%inflation. Their rates have dropped marginally, from 22.1% to 21.8%. 

Greek inflation dropped quite a bit. After dealing with 10+% inflation since May, Greece saw an inflation top of 12.1% in September. In October, the rate dipped to 9.8%.

Spanish and Cypriot inflation rates dropped from 9%, with Spain landing at 7.3% and Cyprus at 8.6%. 

These numbers become more encouraging when we disaggregate them and look at the 12 sectors of consumer spending for which Eurostat reports inflation data. 

However, there is bad news, namely, inflation in the sector for household products and utilities. In September, the average EU inflation rate for this sector was 22.3% (21.1% for the euro zone), but four countries have seen prices in this sector increase by more than 50% in the past year: Lithuania (67.7%), Estonia (67.1), Netherlands (61.0), and Latvia (51.5). 

Only four countries saw inflation in this sector decline from September to October. As a silver lining, in most countries where this inflation rate is still rising, the jumps are for the most part small.

Food prices are the second-biggest source of overall inflation. The EU average is 15.4% (13.9% in the euro zone), but the top rates are quite serious: Hungary (37.6%), Lithuania (29.5%), Latvia (27.7%), Bulgaria (25.2%), and Estonia (24.5%). 

Curiously, the ten countries with the highest food-price inflation rates are all in eastern Europe, with Slovakia (23.3%), Czechia (21.4%), Romania (19.9%), Croatia (18.6%), and Poland (18.2%) rounding off the list. 

Not all is bad in terms of food-price inflation. Five countries saw a lower rate in October than in September: Croatia, Denmark, Greece, Lithuania, and the Netherlands. 

The really good news on the inflation front is in the transportation sector. Here, 22 of the EU’s 27 member states saw inflation decline in September; four countries experienced only modest increases. 

Germany, on the other hand, suffered a leap in transportation inflation, from 4.5% in August to 13.9% in September. This sharp rise affected the overall transportation inflation rate for the EU, which rose modestly from 11.1% to 11.6%. This was due entirely to the size of the German economy, which outweighed the drops in transportation inflation in 22 other EU states.

While prices on transportation services—including fuel—are still rising, the inflation rate has been dropping since June across most of the EU. All other things equal, a prudent prediction would be price stability for all of Europe, possibly with the exception of Germany, by February. But that prediction really depends on the ‘all other things equal’ qualification.

To pile on with good news, inflation is also generally retreating in two other sectors: recreational services, and communications services and equipment. 

It is worth remembering that inflation, as conventionally thought of, is not the only force pushing up the cost of living. We tend to forget that interest rates also contribute to inflation: the interest rate we pay on mortgages and other loans is simply the price of the credit service that the banks provide. Interest rates have risen quite a bit over the course of this year, in America as well as in Europe. 

There are clear indications that America is at the end of its interest-rate rally. Rates began rising when the Federal Reserve started delivering on its promises to reverse its exceptional pandemic-related monetary expansion. They kept rising until 2-3 weeks ago when interest rates on U.S. Treasury securities stabilized at around 4%. Yields on auctions, where the Treasury sells new debt, have also stopped rising, or are rising much more slowly. 

In other words, as far as the U.S. economy is concerned, bank customers can expect better news when applying for mortgages. From mortgage and car loans to credit-card debt, even investment credit for small businesses, the cost to borrowers will stabilize and become more predictable in the coming months. Together with subsiding inflation, this creates a positive outlook on the future of the U.S. economy.

The European outlook is similar, but weaker. Figure 2 suggests that interest rates on all-credit-rated euro-denominated sovereign debt—here exemplified by four mid-range maturities—are stabilizing. It is too early to say with confidence that this is the case, but the most recent numbers look hopeful:

Figure 2

If interest rates are indeed stabilizing in Europe, it means that the cost-push on households and small businesses will be over in the spring. Interest rates change rapidly—and stop changing with the same abruptness—but their influence on our cost of living lags behind. Banks will change their interest rates gradually, and unless you have a flexible-rate mortgage, a lower interest rate will not affect your private finances until you refinance your loan or sell your home.

The impact of lower, or stabilized, interest rates comes instead in the form of newly issued credit. It takes time for new, cheaper loans to affect household finances at any macroeconomically visible level, but once it happens, it gives the private sector of the economy a nice boost. The nice thing about lower interest rates, namely, is that people do not need to get a raise to be able to afford a new car loan: all it takes is for the interest rate to fall.

Again, I am not predicting lower interest rates, only stabilized ones. There is a possibility that rates will decline at some point, but I do not see any substantial drops in the next few months. In the meantime, we will have to make do with stabilized rates, which is good since credit at least won’t get more expensive.

There is one more good piece of news as far as inflation is concerned. The leading currencies of the continent have spent most of 2022 weakening against the dollar. That trend got a lot of attention recently when uninformed pundits erroneously blamed the drop in the British pound on Chancellor Kwarteng’s tax-cut plans.

Europe has now come to a point where money is flowing back. Figure 3 shows how many euros, pounds sterling, and Swiss francs, would be needed to buy one U.S. dollar. After reaching their weakest point in late September, all three currencies have slowly grown stronger:

Figure 3

A stronger exchange rate is good for cost of living, as it lowers the cost of imports. Inflation in import prices is lowered and may even reverse into deflation.

All in all, as far as inflation is concerned, the European economy appears to have reached its worst point. The turnaround will be slow and arduous, but it will happen. The only prerequisite is that governments with itchy tax-and-regulate fingers sit still and do nothing (good advice in general when it comes to government) while the private sector pulls Europe out of its slump.