Soaring inflation is not sparing the euro zone. The nature of this imbalance is not the same as in the United States. Even if the level of inflation is even lower than that observed in America, the situation actually seems much more worrying and the remedies are less obvious. At the same time, the ECB remains much more in the background than the Fed on the prospects for monetary normalization.
Galloping inflation in Europe as in the United States
According to the recently released consumer price index, the‘US inflation has risen to 8.6% over the past year. This is the highest level since forty years.
At first glance, it would seem that European countries are going through the same inflation problem: 8.3% in Spain, 7.4% in Germany, 6.9% in Italy or 5.8% in France. More generally, at the euro zone level, on a year-on-year basis, inflation reached 7.4% in April and 8.1% in May. This is the highest inflation rate since the creation of the monetary union.
Different inflation dynamics
One might think that the two phenomena are analogous. In reality, these figures hide two very different dynamics between the two continents. On the one hand, US inflation seems general and, above all, linked to national phenomena. We are seeing substantial price increases in components that are traditionally not very volatile at the housing stage. In fact, the monthly growth of the house price index in America is the highest since 1990.
Conversely, in Europe, inflation is mainly concentrated in volatile sectors often prone to these runaways. In the first place, energy and food, which have suffered from the major supply shocks observed in recent months. Indeed, the core CPI, which excludes these two categories from the calculation of inflation, is three percentage points lower in Europe than in the United States. Rising energy costs saved approximately 2% of overall annual inflation in the United States. In the euro zone, this figure is 4%.
These comparisons clearly indicate that the euro zone’s inflation problem is different from America’s.
On the supply side
The level of American demand is now higher than its pre-COVID level, which is not the case in the euro area. It should be remembered that European growth was particularly anemic before the health crisis with consequent unemployment. Regarding (official) inflation, it had been for more than a decade below the ECB’s 2% target. Some economists even thought that deflation was the real threat and that globalization had killed inflation.
As if printing hundreds of billions amid underinvestment in energy infrastructure and peak oil won’t sooner or later affect the value of the currency…
In Europe, so inflation is clearly not a problem of excess demandit is rather a supply problem. The Old Continent has experienced unprecedented shocks in recent months in the energy field. Russia’s invasion of Ukraine was not done to accentuate the shortage of natural gas.
Final consumer prices have not been fully passed on. We can therefore legitimately think that the evolution of the price of energy remains a crucial factor in the inflationary dynamic.
Wages stagnating in Europe
The euro zone finds itself in a much more difficult situation than in the United States: high inflation and moribund growth. In the USA, incomes are rising and real output growth is rapid and accompanied by inflation. Conversely, in Europe, wage and income growth is weaker and inflation just as high. In Europe, a large part of inflation is imported and affects prices, but not wages. US inflation is therefore less painful than European inflation.
When we step back, we can analyze this development as the flip side of the coin of the economic choices made during the pandemic. European welfare states quickly put in place programs to maintain the level of employment and guarantee income (the “whatever it takes”).
Conversely, the United States did not have the capacity to put in place such massive measures and so quickly. The flexibility of the American labor market has therefore led to massive restarted. It was only later that the US government decided to inject billions of dollars in stimulus to stimulate demand and boost employment.
The gas problem
European natural gas prices have started to soar mid 2021when the Russian exports began to decline and European gas stocks dwindled. Since then, prices have only increased, even though Europeans can hardly change their behavior, because much of the domestic heating is provided by natural gas.
In 2019, Russia created nearly 50% of German natural gas imports. The war in Ukraine is therefore an essential element in understanding the problems of energy supply. Even if Ukraine is falling, the confrontation with Putin is likely to last. Tsar Putin made a reference to Peter the Greata few days ago.
The only serious alternative for Europe is therefore to turn to the United States to acquire their liquefied natural gas (LNG). It’s about only allied country able to protect Europe from even greater energy shortages.
American gas: Europe’s salvation?
Total US exports to Europe are currently about 20% of total EU consumption. However, such a shift would take time because the United States is currently full liquefaction capacity. Admittedly, the demand for LNG from Asia has collapsed following COVID lockdowns in China and Hong Kongbut this demand could return if China change in health strategy.
European natural gas futures August 2023 are only trading 10% below 2022 futures. This therefore shows that the high level of gas prices should remain in 2023. The German think tank Dezernat Zukunft has shown that German households will lose on average 221 to 442 euros due to rising electricity and natural gas costs in 2022 and 472 to 897 euros in 2023.
One of the decisions that could be implemented in order to mitigate inflation would be for Germany to follow the Belgian example and extend the life of its latest nuclear reactors. Otherwise, the country will have to use more for the production of electricity from coal.
Or maybe once the emotion has passed, the German leaders (already reluctant to deliver arms to the Ukrainians) will end up reconnecting with the Russian service station as they have been doing it since 2014 ?
The ECB timidly changes its strategy
25 points to eradicate inflation
While the Eurozone has a different inflation problem than the United States, it is nonetheless pursuing the same strategy. In the wake of the Fed, the ECB recently announced that it plans to raise rates for the first time since 2011. At this stage, the Governing Council has announced its intention to increase its key interest rates by 25 basis points at its July meeting. The ECB should in theory get out of the negative rate path by the end of September. As a reminder, the interest rate on deposits is currently at -0.50% (lowest historical level).
On the way to regression?
The ECB estimates that annual inflation should reach 6.8% in 2022, increase to 3.5% in 2023 and 2.1% in 2024. (Inflation predictions are worthless and economists are always wrong). The ECB does not seem to learn from the American example, which took too long before acting according to the admission of its leaders. If inflation expectations deteriorate, rate hikes will have to be even more massive. And 25 points will certainly not be enough.
At the same time, the Central Bank revised GDP growth expectations for 2022 down by 1%. This would be close to 2.8% in 2022, 2.1% in 2023 and 2.1% in 2024. Just like the Federal Reserve, aware of the unpopularity of inflation, the ECB seems to be opting for lower inflation.
More difficult financing conditions
The spreads between the bonds of southern European countries such as Italy or Greece and the Bund are spreading rapidly, which indicates worsening financial conditions and a more difficult borrowing environment for national governments. This is also the case for companies that are subject to stricter financial conditions than in the United States.
Even if Christine Lagarde seems to have changed her discourse on monetary policy, the fact remains that the ECB certainly cannot afford to relive as large as those that the Fed. The latter has the ability to quickly increase its rates without colossal damage to the economy thanks to the hegemonic position of the dollar.
The economic performance of the euro zone since the end of the 2000s has been deplorable. The continent has suffered from more than a decade of extremely weak growth. The current inflationary crisis represents another difficult challenge for the continent’s economic policy makers.
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