With or without monetary restriction, the specter of stagflation

With or without monetary restriction, the specter of stagflation ...

Inflation isn't always and everywhere the same. It's like Covid, there are variations, and in Europe we have a bad variant.

Inflation is divided into two categories: demand-pull and cost-push. On the other hand, the inflationary impulse comes directly from production costs, which may fluctuate due to independent factors relative to the economy's macroeconomic conditions. This is the type of inflation that we have seen in other developed countries.

Inflation of import-cost-push inflation is especially problematic for monetary policies because it results in what is termed stagflation, higher inflation combined with an economic downturn, even independent of monetary policy. This occurs because while higher costs translate into higher prices, negative impacts for the economy arise through three main channels (Battistini et al., 2022).

The first and most straightforward is the real income effect on households. Other things equal, the energy shock raises consumer prices and, as long as nominal incomes are not immediately and perfectly linked to the consumer price index (CPI), households suffer from a purchasing power decrease.

This variation may not be evenly distributed across the consumption basket. Hence the rise in household energy expenses drives households to reduce other expenses in the budget. This way, the cost push not only results in decreased demand and GDP, but also results in sectoral spillovers from the sector(s) where the cost shock originates to others.

The real energy price (REP) is the effect of the real exchange rate on the energy price. The REP is the difference between the energy price at origin and the currency exchange rate. In one year (05:21-05:22) we had both a higher price at origin and an additional euro depreciation of 17%.

What is the problem? If the importation of goods to domestic goods is increased, this should lead to a substitution from the imported to the domestic goods, and this is generally regarded as a means to improving the foreign trade balance, provided the two kinds of goods are substituted. If they are not, as in the case under consideration, the real depreciation has entirely a different, and perverse, effect, namely it damages the trade balance and the current account.

According to ECB estimates, the euro area current account has improved by around one point of GDP since early 2021, with the negative drag almost entirely due to an increase in the imported energy bill of about 3.5 percent of GDP.

The damage of the current account reported above is possible as the other side of the coin of the households' negative income effect of the energy shock.

The third factor is the terms of trade effect, the ratio of the GDP deflator to the energy price. As the latter rises, the TOT falls, resulting in a transfer of purchasing power abroad, which, at the end of 2021, for the euro area was on the order of 1.3 percentage points.

All of these effects are stronger in more energy-consuming and energy-dependent nations, which means they are stronger in Europe than in the United States.

Lesons for monetary policy

Inflation is first and foremost a change in relative prices with both demand and supply-side effects, according to lesson number one. If conditions exist, it may even manifest itself as a structural change.

Stagflation is inherent in imported energy shocks, independently of any monetary restriction. It is a heavy burden on the whole economy that we cannot ignore. We must only seek to find the finest policy mix to minimize the negative economic effects and to halt further inflationary pressures.

Traditional wisdom holds that monetary policy is inadequate, if not counterproductive, to correct real, structural shocks.[3] A monetary restriction would just decrease demand across all sectors, resulting in a lower otuput loss (see Bonatti and Tamborini, 2022, for a simulation).

Therefore, monetary policy may be justified as long as an endogenous decline in demand and activity is ongoing, and that it may be halted in the medium and long term. Wage dynamics and expectations are two important things to keep an eye on.

The ECB's decision whether, when, and how much to taper its purchases of government bonds and raise its policy rates to dampen inflationary pressures will inevitably appear highly political in the euro-area.

Officials at the European Central Bank (ECB) are well-versed in their delicate position and are calling for a "credible backstop" for euro-area stability[5]. This implies that the central bank cannot bear the entire burden of banking.

In this context, appropriately oriented fiscal policies, both at the national and EU central level, may help to complement monetary policy moving from stimulus to normalization. Examples include fiscal sterilization of households' energy bills, which may reduce wage-price spirals, and subsidies for energy sources substitution[6].

The post-pandemic legacy, the stagflation shock, and the economic and strategic implications of Russia's new international position, as well as EU Member countries' commitments to a green transition, all contribute to an increase in governments' borrowing needs.

The successful synergic coordination of monetary policy with central and national fiscal policies established in response to the epidemic should be strengthened.

Press Conference on Monetary Policy Report of the Bank of England. "Starting Remarks", May 5.

"Energy prices and private consumption: What are the channels?", in ECB, Economic Bulletin, n. 3, 2022.

"Economical Policy Implications of the Russia-Ukraine War for the European Union," Blanchard O. J. and Pisani-Ferry J. (2022), Peterson Institute for International Economics, Policy Brief, n. 22-5.

"The ECB and the Ukraine conflict: threats to price, economic, and financial stability," Bonatti L., Tamborini R., "Publication for the Committee on Economic and Monetary Affairs, Monetary Dialogue Papers, European Parliament, Luxembourg, June 2022.

Schnabel, I. (2021), Monetary policy and financial stability, Address at the European Systemic Risk Board's fifth annual conference, 8 December.

Whelan K. (2021), "Central Banks and Inflation: Where Do We Stand and How Did We Get Here?", CEPR Discussion Papers, n.16557.

The United States is facing a demand shock, with a robust domestic labor market and relatively little exposure to the energy price shock due to its position as a major gas producer. The euro area, on the other hand, is facing a supply/cost shock, as it starts with a somewhat smaller domestic labor market, and is heavily exposed to the rise in gas prices. Both are components of the UK's strong labor market, according to Bailey, 2022.

[3] Over the last twelve years unprecedented monetary stimuli all over the world have produced almost nonexistent effects on obduratley very low inflation until other events and factors have arisen.

[4] For those reminiscing about the stagflation of the 1970s and the so-called "Volcker disinflation" of the early 1098s, it is worthwhile to note that "the Federal Reserve successfully and decisively reduced inflation". Yet "the result was a tumultuous period for monetary policy and the economy [including] extreme volatility of the federal funds rate [].

"The euro area remains vulnerable to fragmentation due to its current structure, which may result in unexpected policy adjustments that are more severe than expected," according to Schnabel. "A credible backstop that commits to combating such risks of fragmentation might help protect against disorderly movements and thus enable the central bank to focus on its price stability mandate."

[6] "The more fiscal policy protects the real income of workers, the less likely the demand for wage increases is to be in future rounds." The more a decrease in inflation becomes credible, the less the European Central Bank (ECB) will have to tighten in order to reduce inflation. In effect, larger deficits can result in a lower output cost of combating inflation" (Blanchard and Pisani-Ferry 2022).

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