where do we come from and where are we going

War is inflationary. However, the current inflation comes from before the conflict in Ukraine. According to Eurostat, in January 2022 year-on-year inflation had already reached 5.1% in the eurozone when in December 2019, before the pandemic, it was only 1.2%. The figure of 9.1% for August 2022 – the highest in the last 50 years – has two potential causes acting at the same time:

The offer

The physical war on the Russian front against Europe and the economic war between the United States and China affect three main factors:

1. The energy supply to Europe is used as a geostrategic weapon.

2. The production capacity of the world’s factory, China, is reduced due to its policy zero covid.

3. Maritime supply chains become slow, insecure and inefficient.

The demand

After the appearance of covid-19, the large economies (including Europe) were rescued through the largest program of monetary and fiscal stimuli in history. The amount of money in circulation was increased -by printing banknotes through bond purchase programs-, interest rates were reduced to historical lows and public transfers were made to companies and citizens to maintain their spending capacity in the quarantine and lockdown periods. mobility restrictions.

In this way, with a supply constrained by the difficulties in global trade and in the world energy sector and a runaway demand due to the amount of money available, inflation -which is nothing more than the mismatch between supply and demand reflected in the prices – pushes up.

The actions

The main objective of the European Central Bank (ECB) is to maintain price stability at around 2% and thus the value of the euro. Obviously, a central bank has nominal power, not real power. That is, you can print money, but not gasoline or raw materials.

Its power is solely to slow down the demand side so that it engages with the new paradigm of lower supply. Therefore, although the causes of inflation are not monetary, but supply problems, the ECB can only act monetary and, therefore, not directly on the causes.

Various central banks, including the US Federal Reserve, began to react to rising inflation from the end of 2021. However, the ECB, which had maintained interest rates for the eurozone at 0% since the beginning of 2016, remained expectant until mid-July 2022. Therefore, the current rate hike ends a long period of abundant and cheap money in Europe.

The effects

The most important effect of the general rise in interest rates at a global level is that, in the words of Jerome Powell, president of the FED, the slowdown in the economy will imply pain for families and companies, since global demand will tend to decrease and, with it, the levels of economic activity and employment.

In addition, there are two additional effects that deserve to be highlighted:

Interest rates and commodities

This also affects the price of raw materials, since the expectation of less activity implies less demand for these materials and, therefore, falls in prices. In the case of oil, the producing countries gathered in OPEC and Russia have anticipated this situation and have announced a reduction of two million barrels per day in production.

exchange rates

The relationship between currencies has been affected by the temporary decoupling in the rise in interest rates. From mid-2021, just over 20% against the euro. Then a euro cost 1.22 dollars while in the fall of 2022, a euro costs just under a dollar. The appreciation of the dollar implies the depreciation (the loss of value) of the euro against that currency.

Interest rate differentials move money to where it pays the most, and since the Fed started its rate hike cycle first, it increased the dollar’s appeal against the euro. In addition, the eurozone is selling huge amounts of euros to import energy resulting in a rapidly widening trade deficit, which is also weighing on further currency weakness.

These variations are not harmless in the economy. When a currency appreciates, aggregate demand tends to contract on its external side as exports become more expensive and imports become cheaper. At the same time, the appreciation of the currency reduces the inflationary component of a country’s imports since, as has been pointed out, it makes them cheaper. Both effects tend, on the one hand, to slow down economic activity and, on the other, to reduce price growth.

The effects on the depreciating currency are exactly the opposite, which makes it difficult, in this case for the eurozone, to control inflation and the expansion of aggregate demand.

Where are we going

In this scenario, could the ECB not have tightened the financing conditions of the European economy? The answer to this question could have been yes: the ECB could have expected agreements on income policy (price and wage controls).

However, if the difficulty of specifying a policy of this type is high in a single country like Spain, the enormous heterogeneity of situations among the 19 countries that make up the euro would have made, we believe, that wait too long. What does not prevent, on the other hand, to point out that both policies should act simultaneously in order to minimize the period of pain in the European economy.

In the current situation, with Europe being hit on different economic and geopolitical fronts, uncertainty is enormous and the route that the ECB follows in its next actions will depend on external factors (such as war, the functioning of value chains, etc. ). However, the credibility of the institution and the euro will continue to be the most difficult task that the ECB has faced since its creation.

The balance to be achieved is difficult since an excess of zeal in the fight against inflation could imply an economic recession, with the high social costs that this implies. On the contrary, a high degree of laxity in its actions could lead to a loss of control over the evolution of prices and, consequently, to the deterioration of the credibility that the European Central Bank has had since its creation in June 1998.

Guillermo Matesanz Estebaranz is co-author of this article, which has its origin in Letter number 37 of the GETEM (Study Group of the Transformations of the World Economy) “Inflation and monetary policy in the eurozone. Where do we come from and where are we going”, published in September 2022.

David Matesanz Gómez, Professor of Applied Economics, Oviedo University

This article was originally published on The Conversation. Read the original.