Has inflation been tamed?

Whether high inflation has become embedded in economies remains a moot point. While inflation has started falling, it’s going to be tough to bring it back to pre-Covid levels.

High inflation has plagued many developed economies since mid-2021.  The European Central Bank (ECB) has taken forceful action in response to the unprecedented surge inflation in the Euro area, raising its key interest rate from -0.5% to 3.5%.  Policy tightening has managed to bring down inflation from 9.9% in September last year to 4.9% last month (in Malta: 4.9% vs last year’s 7.4%). This has meant sluggish growth in GDP, though not in Malta.

As one would expect, inflation in Malta is normally very close to the Eurozone average, as the 12-month moving average between 2012 and early 2021 in the chart shows. 

Contrary to what one would think if one listens to the Opposition, the fact is that, since August 2021, our inflation has dipped below that of the Eurozone.  The chart also shows energy and food prices in Malta since 2016.  Energy subsidies were, of course, instrumental in keeping prices in Malta contained, though food price inflation has consistently been higher than the overall index. 

In spite of this positive result, it is still debatable whether the ECB will be able to bring inflation down without causing a deep recession and high unemployment.  This, in turn, could cause worries in the banking sector and hurt sectors like manufacturing and construction, though the short-term outlook is much stronger in services where the post-Covid rebound continues.

What stands out in the post-Covid economic scenario is that core inflation (the change in the costs of goods and services, excluding those from the food and energy sectors) has been too high.  The decline in headline inflation (the total inflation in an economy) has been almost entirely due to low energy prices but broader price pressures are still strong.  Robust monthly changes in both service and non-energy industrial goods prices have persisted, boosting annual core inflation numbers.

What lies ahead?

Looking ahead, ECB staff projections show headline inflation decreasing to 3.2% in 2024 and 2.1% in 2025. This decline in headline inflation extends to all the main components of the price index, albeit to varying degrees. The decline will initially begin in the energy and food components and then be taken forward by fiscal policy measures and weakening commodity prices.  Core inflation is projected to moderate more gradually, from an average of 5.1% this year to 2.3% in 2025, as supply interruptions recede and the tightening of monetary policy increasingly impacts economic activity.

Disinflation is being spurred by a reversal of the supply-side shocks that had caused the unprecedented surge in inflation.  Surveys show that bottlenecks in the global manufacturing sector have by now fully unwound and that input prices have fallen to the lowest level in many years.  At the same time, however, it appears that service price inflation will remain strong due to high wage increases. Mind you, the system of centralised wage negotiations in many countries, including Malta, implies that the rapid increase in wage costs will be a sticky phenomenon now that it has started.

One complication the ECB has had to grapple with is the challenge of highly uncertain inflation forecasts.  One source of uncertainty stems from companies’ pricing power. In general, it seems that businesses have been able to increase their profit margins, though this trend could quickly reverse if demand weakens, with downside risks for the economy as a whole.

European energy prices have come down from their 2022 heights of $122.71. per barrel and are now back to more normal price ranges, trading at around $83.467 per barrel, while European gas prices are trading at $55 per megawatt-hour compared to $150 per megawatt-hour in 2022.  Another good sign is that Europe now has ample gas storage levels.  

As far as households are concerned, electricity prices in the first half of 2023 were considerably down, at €0.2335 per kWH (Malta: €0.1181/kWh) versus the 2022 peak of €0.2525/kWh in the EU (Malta: €0.1293/kWh). While price spikes cannot be ruled out, the European Commission expects energy prices to remain low.

Euro area GDP growth, which had slowed down in the first quarter of 2023, rebounded somewhat by 2.8% in the second quarter of 2023, while Malta’s rose even more strongly, by 6.5%. On the other hand, the latest Composite Purchasing Managers’ Index (PMI) numbers in the Eurozone took a surprise turn for the worse this month, down to 43 – the lowest number since January, when it was 49.  This indicates that the tighter monetary policy and the decline in household purchasing power have negatively affected manufacturing.  No PMI figure is available for Malta, except that, back in August, the manufacturing production index was reported by the NSO to have fallen by 11 percent, though through the year it had been on a generally rising trend.

On the other hand, positive developments in the service sector will likely boost the labour market, which is already very tight. The unemployment rate was a record-low at 6.4% in August in the Eurozone (Malta: 2.7%), and companies continue to see shortage of labour as the biggest growth obstacle. Labour market tightness coupled with high inflation has led to significantly higher wage increases than the Euro area is used to (4.5% in nominal labour cost in the second quarter of 2023; Malta + 2.1%). On top of boosting households’ purchasing power, the wage increases also imply that especially service price inflation is likely to remain elevated, further challenging the  inflation target.

In 2021, there had been warnings from some economists that high inflation might not be “transient”, as major central and various think tanks were claiming at the time when they said rapid price rises wouldn’t last long. Whether high inflation has become embedded in economies remains a moot point.  While inflation has started falling, it’s going to be tough to bring it back to pre-Covid levels.

Central banks often point to the war in Ukraine and spiking energy prices when explaining recent rapid price rises. But inflation in certain G7 countries was already at a four-decade high before the start of the war. The truth may be that the global economy has entered a period of permanently higher inflation fuelled by four deep forces.

Long-term forces driving inflation

  1. One of the long-term drivers of inflation is an economic cold war.  Trade sanctions against China and then those against Russia because of the Ukraine war have reversed many of the advantages of globalisation.  Politicians in the US and EU are engaged in protecting jobs, rejuvenating industries, and reducing national trade deficits by weakening the local economy’s global ties.
  2. Then there is climate change which, with its unstable weather, is hindering production and even making natural disasters more likely. Like pandemics, these events disrupt production and can be costly for businesses to manage and overcome. Increased costs are passed on to consumers, as are the costs of government initiatives such as carbon taxes.
  • The third force is the possibility of a wage-price spiral – this is when high inflation pushes up wages, which then boosts demand and spending, leading to more inflation. It’s a vicious circle that affects service-based economies (like Malta’s) the worst.  There is some evidence for this, though not all experts agree that it will be a permanent feature in the medium-term.  Employers in Malta have joined the bandwagon, even though the facts so far show otherwise.
  • A fourth force is the liquidity that exists in economies. Following the 2008 global financial crisis, central banks pumped more money into economies through a convoluted process called quantitative easing (QE).  What started as a reasonable measure to shore up the banking sector and help households and businesses via low interest rates became an addictive habit. One only has to look at the Liquidity Coverage Ratio (the proportion of highly liquid assets held by financial institutions to ensure that they maintain an ongoing ability to meet their cash outflows for 30 days).  The minimum is 100%, but in March this year it ranged between 147.7% in Luxembourg and a whopping 419.7% in Lithuania.  In Malta the figure was 177.4%, versus the EU average of 163.7%. Economic theory suggests such extreme liquidity would cause inflation. This hasn’t happened but it has overly-boosted the valuation of all assets, such that we can now say that we are in an “everything bubble”.  The problem is that excess liquidity makes it harder to fight inflation.

Where are the concrete suggestions?

Unfortunately, there are rarely any miracle solutions in economics. For a long time the PL used to criticise the PN government for inflation in Malta.  Now it’s the turn of the PN to criticise the PL government.  Apart from apportioning blame, there is often little in the way of concrete suggestions.

In spite of the hullabaloo about thousands of foreign workers in Malta, this has alleviated labour shortages, boosted production, and kept inflation lower.  Other remedies could be investment in technology, people, and infrastructure.  However, the bluntest remains the use of interest rates and credit squeezes, which are highly effective but not very selective.

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