6 minute read
High inflationary pressure in transatlantic region
for new public infrastructure in the energy sector. This will demand permanent adjustments in public revenues and expenditure. National and EU-wide loan financing for certain priority projects could be possible in individual cases but will not be able to shoulder the bulk of the adjustment costs. This means that almost all countries will have to make painful adjustments to their budgets (OECD 2022, PisaniFerry and Blanchard 2022).
Financial policy can only mitigate impact
Financial policy generally only has very limited scope to respond to a double shock, mainly in tweaking distribution. Stabilising aggregate demand by stimulating demand will not help counter the current supply shock. Conversely, stepping up consolidation risks snuffing out the already weakened pace of growth. Countries under particularly high inflationary pressure must also consider to what extent their fiscal course is boosting demand and therefore contributing to inflation.
Governments in developing and emerging countries have so far hardly adopted any packages of measures to mitigate the impact of the shock. Most of these countries are, in fact, going the opposite way and pursuing monetary tightening in response to the United States’ turnaround on interest rates. As many countries have also seen growth and state revenues drop on account of Covid, there is very little leeway to implement measures to protect against higher energy and food prices other than those aimed at reducing poverty.
The Ukraine war has fundamentally changed the outlook for inflation. Before the war, an increase in inflation rates seemed plausible given the supply bottlenecks and strong pace of growth. Since the war started, the inflationary momentum is unmistakeable with prices for energy and agricultural commodities and some metals shooting up within a very short space of time. Supply bottlenecks in the production of intermediate products have intensified further, as have the disruptions in international shipping and logistics in the wake of sanctions against Russia and the closure of Russian airspace. The situation is compounded by the problems in transport and logistics in China on account of the country’s zeroCovid strategy.
In response to such a broad increase in input prices, many industries around the world first compressed their margins or curbed production. This will gradually lead to rising producer prices and, ultimately, albeit to a lesser extent, rising consumer prices. The OECD estimates that between 40 and 50 percent of the price increase will be shifted onto consumer prices.
While industrialised countries only had an inflation rate of 0.7 percent in 2020, it increased to a good three percent in 2021. This year, inflation is expected to reach extremely high levels. The IMF (IMF 2022) expects inflation to reach 5.7 percent this year in industrialised countries and 8.7 percent in developing and emerging countries (1.8 and 2.8 percentage points more respectively than in January). Core inflation most recently rose to four percent among industrialised countries and five percent among developing and emerging countries. The IMF expects inflation to calm down by next year already and drop back to 2.5 and 6.5 percent respectively. The OECD anticipates inflation this year to average 6.2 percent in the United States, 6.1 percent in the euro area, and around three percent next year (OECD 2022). Inflation has risen particularly rapidly in the United States, the United Kingdom and in countries of Central and Eastern Europe. In Europe, inflation is being fuelled by surging gas prices, in particular, whereas in the United States it is the oil prices. In almost all countries, the inflation rate has
also risen in the service sector as business returns to normal and service providers restricted during Covid initially struggle to find enough workers.
Risks that households and financial markets will be faced with permanently higher rates of inflation and higher wage rises have nonetheless also increased. The factors affecting inflation are usually outside the scope of influence of monetary policy. In the United States, the Biden administration’s highly expansionary approach has definitely helped drive inflation up further, whereas, in Europe, fiscal policy has not been too expansionary on the whole. The central banks of the United States and Europe are in a difficult position. For the first time in a long time, they now need to normalise monetary policy, reduce bond purchases, and increase interest rates in order to curb demand. Every currency area will have to take a differentiated approach as both the factors driving inflation and the consequences differ. China is an exception here, with its central bank loosening monetary policy as the lockdowns have considerably weakened its economy. Japan is following the general trend but, with inflation at below two percent, it is no cause for major concern as yet.
Inflation rates should gradually decrease over the second half of the year and next year, at least if the energy prices ease off as signalised by the futures prices. Inflation is nonetheless set to be higher for longer than seemed plausible before the outbreak of the war. The central banks will therefore have to normalise their monetary policy to a greater extent in order to counteract the upward pressure. The OECD expects an average increase in base rates within its countries of two percentage points (comparison between annual average 2023 to 2021) (OECD 2022). Over the last few weeks, the pace of monetary tightening has accelerated in many countries in response to the unexpectedly high upward inflationary momentum.
U.S. central bank announces substantial monetary tightening
Inflation has risen particularly steeply in the United States. In December, the Fed had already anticipated that inflation would exceed five percent, but the momentum has proved to be even stronger. Inflation in May was at 8.6 percent with core inflation at six percent, triggering a strong reaction from the central bank. The Fed thus emphasised recently that, despite the expected weakening of economic activity on account of the war, a robust monetary policy response was now needed to counteract the various imbalances, the very tight labour market, and the broad pressure on prices (energy prices, pandemic effects, services, rents, wages). It has accordingly cut back its bond purchases (net) extensively since the start of the year and, on 4 May, increased the benchmark interest rate by 50 basis points to a target range of 0.75 to one percent as well as signalising two further interest rate hikes on the same scale until September. The Fed further resolved to reduce its balance sheet with net sales of assets (U.S. Treasury and mortgage-backed securities) beginning 1 June, initially on a small scale and then, from September onwards, at a volume of roughly 95 billion U.S. dollars per month. The Fed’s balance sheet had reached around 5.8 trillion U.S. dollars in government bonds and 2.7 trillion U.S. dollars in mortgage-backed securities and plans to cut it by around one trillion next year alone. On 15 June, the Fed took the next step, increasing the benchmark interest rate by 0.75 percentage points to a range of 1.5 to 1.75 percent. Further interest rate hikes are on the cards. The midpoint of the target range of individual members’ expectations was up by 1.5 percentage points to 3.4 percent for the end of the year, and up by 90 basis points to 3.8 percent for next year.
The precise scale of the increase will depend on the upward movement of financing conditions and on the development of the labour market. The labour market currently has a very high number of vacancies compared to the number of unemployed persons. In view of the surging inflation and the little
