Focusing on the relative strength of price components as a causal factor does not allow us to look at the phenomenon as a whole.
There is an increasing tendency to look at the different components of prices to identify what is contributing the most to core inflation. Obviously, some observers took the view that today’s price increase is "Putin’s inflation", due to the role the Russian invasion of Ukraine played in driving up energy costs for businesses and households last year. This interpretation has created the illusion that inflation will be much lower in 2023, since energy prices are not expected to rise further this year. As a result, some commentators in the United States and Europe warn that the tightening of monetary policy by the US Federal Reserve and the European Central Bank risks being excessive.
Such warnings are premature, if not counterproductive. Inflation tends to become persistent due to second order effects. Not only have producer prices increased much more during this period, they have not yet fully translated through the value chain. Furthermore, nominal wages have already increased or will increase this year. For example, the 2023 wage increases agreed between trade unions and employers’ organizations in the euro area already amounts to 5%. As companies look to pass these costs on to their customers, core inflation will likely remain higher than forecasts currently suggest.
Focusing on the relative strength of price components (such as energy prices) as a causal factor does not allow looking at the whole phenomenon. Inflation is still what it always was: a macroeconomic phenomenon that results from the imbalance between aggregate demand and aggregate supply. As such, it is affected by monetary and fiscal policy.
To illustrate this point, just go back to 2021: at 4.7%, the inflation rate in the US was already high; and in the eurozone, it had started to accelerate by the second half of the year. Energy prices in the eurozone were rising sharply and contributing heavily to inflation before Russia invaded Ukraine. After the invasion, US markets were not particularly affected by the price effects of the war, but inflation continued to rise.
So where did this inflation come from? In 2020-21, fiscal and monetary policy became highly expansionary as policy makers scrambled to cushion the economic effects of the pandemic and stabilize the economy. This has happened globally, but it has been especially pronounced in the United States, where the fiscal stimulus mobilized by the Trump and Biden administrations has been larger than the pandemic-induced GDP decline.
Furthermore, the expansion of US fiscal policy was possible thanks to monetary policy, as the Fed intervened to support aggregate demand. To make matters worse, aggregate supply has declined, due to disruptions in value chains.
The mix of fiscal and monetary policy was similar in Europe. The ECB bought government bonds through its current public sector purchase program (the PSPP, set up by Mario Draghi in 2015) and its new Pandemic Emergency Purchase Program (PEPP). With declining tax revenues (due to the COVID-19 crisis) and government spending to support large stimulus programs, the ECB then refinanced markedly higher budget deficits than member states in secondary markets. Monetary financing of fiscal policy has become effective in the real economy through increased transfer spending, government spending and investment. Price pressures have consequently increased.
There are several lessons to be learned from the return of inflation. First, inflation is a macroeconomic phenomenon. It is insufficient to look only at specific price components such as energy. Second, high inflation today is the result of too much money chasing too few goods and services. As such, inflation may prove to be more persistent than many have acknowledged. Thirdly, the interrelationship between monetary policy, fiscal policy and financial stability plays an important role in the growth of inflation, making debt sustainability and debt expectations crucial factors.
These lessons have three general implications. First, monetary policy must become tight to deal with the current high inflation. Second, fiscal policy should not conflict with monetary policy tightening. And, thirdly, fiscal policy must become more credible and sustainable again. Restoring a stable path towards achieving primary surpluses would create fiscal space and allow primary deficits to be deployed against future crises without a loss of credibility.
Original article published on Money.it Italy 2023-04-17 07:51:54. Original title: Perché l’inflazione non scenderà facilmente?
