As we reported on December 1st, Eurostat has published a new flash estimate of eurozone inflation. The annual rate reached 4.9% in November, up from 4.1% in October. This is far above the 2% target that the European Central Bank adopted in July.
According to Eurostat, inflation is primarily driven by energy prices, which are up 27.4% on an annual basis. However, of more concern for the long term is inflation witnessed in other major products which have also exceeded the ECB target: prices on services increased by 2.7%, followed by food at 2.4%, and non-energy industrial goods at 2.2%.
In other words, inflation is spreading. This is a serious matter: high inflation is one of the most destructive forces in the economy. It erodes paychecks and puts indebted households in financial jeopardy. When it outpaces interest rates, it devalues our savings. Likewise, inflation complicates business investments: it becomes harder to predict the return on long-term commitments to a new factory, new machinery, or workforce development.
While the current rates of inflation in Europe are not yet at destructive levels, they are closing in on that double-digit territory where things can easily spin out of control. Some central banks are responding. The National Bank of Hungary is already raising rates and the Polish Central Bank is expected to follow.
The European Central Bank, however, refuses to raise interest rates and says it is unlikely to do so in 2022 either. This is remarkable, given that the Bank’s role is to maintain price stability throughout the currency union. In fact, the European Central Bank already seems to be losing control over inflation: currently, not a single eurozone member state meets the ECB’s inflation target. Malta has the lowest rate at 2.3%, but in nine countries inflation has already topped 5%. The highest rates are found in Lithuania (9.3%), Estonia (8.4%), Latvia (7.4%) and Belgium (7.1%).
To make matters worse for the ECB, inflation is accelerating. In 17 eurozone countries, inflation has increased every month since June. In Finland, the acceleration started in August, and Portugal has seen a steady rise since September. Yet the only response from the ECB thus far has been to wait and see. The Central Bank seems to believe that inflation is going to go away on its own. In a speech at the Bundesverband der Deutschen Industrie, the German Industrial Federation, ECB board member Isabel Schnabel predicted that inflation will subside in early 2022 and fall back below the Bank’s two-percent target rate.
On the face of it, this forecast seems reasonable, especially since the European Central Bank is not alone in saying that inflation is a transitory problem. As recently as in September, the Federal Reserve predicted that U.S. inflation would fall back to the 2-2.5% bracket in 2022.
Since then, though, the American central bank has modified its outlook. On November 8th, Vice Chairman of the Federal Reserve Richard Clarida referred to inflation as “much more than a ‘moderate’ overshoot” of the bank’s 2% inflation target. Then, on November 30th, Federal Reserve Chairman Jerome Powell suggested, albeit vaguely, that the Federal Reserve System no longer considers inflation to be transitory. It is, Powell explained, a problem that the U.S. economy will have to live with beyond next year.
This change in tone, which comes on the heels of U.S. inflation exceeding 6.2% in October, is welcome, though belated. Throughout the summer, the Federal Reserve maintained that its forecasts placed inflation at about 2% beyond 2021.
In Europe, the ECB’s track record for foreseeing inflation is no better. Over the past 20 years, its forecaster survey has consistently predicted that inflation will never rise above 2%. Surprisingly, over the past two years the survey has put inflation below 2%, both over the short term and the long term.
With such forecasting errors on record, it is difficult to understand why the European Central Bank maintains its lax attitude to inflation. One reason could be a dispute over economic theory: perhaps the ECB inflation experts have simply misunderstood the nature of inflation. This is a highly unlikely explanation, given the abundance of macroeconomic expertise on ECB payroll. But if true, it would explain both forecasting errors and the Bank’s refusal to take policy action to curb inflation.
There are two basic types of inflation: demand-pull and cost-push. The first kind is the classic type where total demand in the economy exceeds total supply. This is a situation where consumer spending is high, where businesses demand lots of new investment products (machinery, computers, vehicles, office buildings, factories, etc.), and where producers are operating at full capacity to meet that demand.
When inflation is driven by high demand, there is virtually no risk that it will spin out of control. For every euro being spent in the economy, there is a euro earned somewhere. For example, consumer spending is paid for by the earnings of a well-paid workforce. Bank credit is backed by collateral, which is a value dedicated to that line of credit. By contrast, newly printed cash from the central bank is money literally created out of thin air.
A free-market economy regulates demand-pull inflation by dampening spending when price increases accelerate too fast. By contrast, when inflation originates on the supply side there is a risk that it spins out of control.
The second type of inflation, referred to as cost-push or supply-side, is frequently explained in economic textbooks in the context of the oil crises of the 1970s. Political instability in the Middle East caused oil prices to rise rapidly around the Yom Kippur War in 1973 and again after the Iranian revolution in 1979.
As a result, producer prices started rising, raising the cost of living on a global level. In 1973, France and West Germany both suffered inflation rates above 7%. British inflation exceeded 9% while Finland, Greece, Italy, Portugal and Spain all had inflation rates in excess of 10%
As the 1970s unfolded, inflation kept rising. By 1980, British inflation had reached 18%, Sweden stood at 13.7% with France a hair behind at 13.6%. While Greece and Italy exceeded 20%, Germany and the Netherlands were lucky to cap at 5.4% and 6.5%, respectively.
There is an important lesson to be learned from that era. Once cost-push inflation makes its way into the economy, it is very difficult to remove. Producers and retailers work the rising prices into their contracts, gradually making a habit of marking up prices to account for expected inflation.
They also shorten their price-review periods. Economics literature suggests that businesses generally review their prices twice a year. However, when inflation rises, price reviews become more frequent, and with higher frequency even small price mark-ups compound into higher annual inflation.
Plain and simple, inflation takes on a life of its own. The current inflation patterns in both Europe and America suggest that we are at a point where this is happening. This, in turn, means that the forecasters surveyed by the ECB have misinterpreted the nature of inflation. Counterintuitive as this is, given the role energy prices play in driving inflation, the belief that inflation is transitory is consistent with the demand-pull theory.
When a monetary policy institution such as the ECB misinterprets inflation, it has negative consequences for the economy. Its policy decisions fail to address the problem and could easily pour more gasoline on the fire. This happened in the 1970s when it took several years for the leading central banks to respond.
If the same mistake is made today, the consequences are likely going to be more serious. In the 1970s monetary policy had not yet been used on any broad scale to finance structural budget deficits. That has changed dramatically since then, especially over the past decade. After the terrorist attacks of September 11th, 2001, the Federal Reserve implemented a small, temporary Quantitative Easing program. The bank implemented a larger version of this in the wake of the Great Recession of 2008-2010. The ECB created its own programs, buying sovereign debt in order to prevent government defaults.
Governments on both sides of the Atlantic became used to central bank support. The U.S. government has not balanced its budget in 20 years; in 2018, half the members of the European Union ran budget deficits.
In other words, the problem with government deficits is much older than COVID-19. An unholy alliance between deficit-prone governments and accommodating central banks has brought us to a point where the monetary expansion is causing inflation.
Skeptics would ask why we have not reached this point before: if the money supply has been outpacing economic growth for more than a decade already, why has this not lit the fuse of inflation before?
There is a simple explanation for this. Money causes inflation by means of so-called transmission mechanisms: in plain English, the ways that newly printed money makes its way into people’s pockets.
As it happens, the foremost money-to-inflation mechanism is government spending. When a central bank prints money to buy sovereign debt, a government gets cash that, in turn, funds benefits and services for its citizens. The demand for those services represents value taken out of the economy without any corresponding value being put back in.
The longer the government continues to monetize deficits, the stronger the transmission mechanism that translates money into inflation. Once it reaches a critical mass, inflation starts rising rapidly. Like ketchup in an old-fashioned glass bottle, first nothing comes, then nothing, then all of it at once.
It is likely that the inflation we are now witnessing is the beginning of the “ketchup effect.” Therefore, central banks must responsibly and rapidly tighten their monetary policies.
Once they do, however, it will have immediate repercussions for the cost of government deficits. That cost hike is no small matter. Since March 2020, the ECB has purchased government debt for almost €2.5 trillion through its Public Sector Purchase Programme (PSPP). This equals more than 21% of all consolidated government debt in the currency area.
The PSPP purchases are 50% larger than the total increase in euro-zone government debt since the start of the Covid pandemic. While this program is not the only asset purchase program in the ECB’s quiver, it is the one that has the most direct effect on inflation.
Both Europe and America need monetary tightening, and the Federal Reserve has already started tapering its purchases of U.S. debt. The ECB is slated to end PSPP in March next year. The question is if it actually can do this, given its explicit desire to not raise interest rates.
In other words, the ECB is trapped in a no-win situation: it has a choice between high inflation on the one hand, and high interest rates on the other. The former has serious consequences for the private sector; the latter hits everyone, including deeply indebted governments. In 2020 the consolidated government debt in Greece exceeded 206% of GDP. Other heavily indebted countries are Italy (155%), Portugal (135%) Spain (120%) and Cyprus and France (115%).
To put the choice between high inflation and high interest rates in perspective, it is worth remembering that interest rates were much higher 25 years ago than they are today. In the midst of the 1990s economy, with strong GDP growth and full employment, the U.S. government paid 6.4% on its ten-year treasury security. Long-term treasury bonds paid 6.3% in Belgium, 7.1% in Denmark and 5.7% in the Netherlands. Car and mortgage loans were at corresponding levels.
Caught between Scylla and Charybdis, the choice for our central bankers is hard but simple: which short-term pain comes with the best prospects for prosperity in the future?