Inflation Premonition

Cost of living prices have been rising across Europe in recent months, with annualised inflation hitting 4.1% in October in the Eurozone. The worrisome figures are increasingly causing concern in national capitals, despite a strong economic rebound since the pandemic, with real GDP growing by 2.2% in both the second and third quarters.

Does it matter for Malta, given that during the same period our annualised inflation rose by just 1.4% in October, against the backdrop of a 0.5% drop in real GDP in the second quarter?

I believe that what happened to inflation in Malta during 2021 is atypical of the normal trend, and can therefore be quite misleading as a guide to what might happen in the next few months.

In fact, whereas a best-fit regression of the annual inflation rate during a 10-year period for the three countries concerned yields an R-squared value in the high nineties for the Eurozone and Ireland, that for Malta yields a significantly lower value. Similarly, if one plots the monthly Harmonised Index of Consumer Prices (HICP) rate over the last two years, the mistmatch is even greater. A best-fit regression of core inflation gives somewhat better results, but clearly the inflation trend in Malta is not mirroring that of its European peers.

I believe that the sharp drop in consumption and concomitant marked rise in savings in the course of the pandemic have momentarily dampened the inflation rate due to a considerable change in consumption patterns. Now that restrictions have been lifted and the economy is back on a growth trail, consumption will return to a more normal pattern. However, the rise in import costs and the labour shortages being experienced will have an inflationary impact in due course.

The inflation trend in Malta is not mirroring that of its European peers. 

Does it matter? Yes. To the extent that households’ nominal income, which they receive in current money, does not increase as much as prices, they are worse off, because they can afford to purchase less. In other words, their purchasing power or real — inflation-adjusted — income falls. Real income is a proxy for the standard of living. When real incomes are rising, so is the standard of living, and vice versa.

Whatever the statistics say, consumers are feeling the brunt of rising consumer goods prices. As every politician knows, bread-and-butter issues have political consequences and can very quickly turn into anger toward the governing party.

France: The marked rise in prices has shot to the top of public concern and looks set to become one of the hot topics in next year’s presidential election. According to a poll last month, 90% of French people were worried about rising prices while 75% thought their purchasing power had shrunk — despite official statistics showing the latter has stabilised with a slight growth of 0.6% in the second quarter of 2021.

Pouncing on public disquiet, some Opposition candidates such as the center-right’s Michel Barnier and the far-right’s Marine Le Pen have vowed to cut taxes on gasoline to counter rising energy costs. The government was forced to present an “inflation compensation” payment of €100 for citizens earning less than €2,000 per month after tax.

Ireland: The Emerald Isle had an annualised inflation rate of 5.1% in October. Alongside that, there was a rapid increase of some 9% in house prices and the Irish public has noticed that. Owners of properties have benefited from it but most others will find it virtually impossible to buy a house. One aspect of the crisis is that the deposit to buy a home is now equivalent to more than 10 years’ saving.   

The reaction came swiftly. Last July, Fine Gael’s Ivana Bacik trounced the government parties on Dublin’s south side, by winning a by-election dominated by anger on the housing crisis. 

It is not the first time that inflation has plunged countries into long periods of instability. Central bankers often aspire to be known as “inflation hawks”. Politicians have won elections with promises to combat inflation, only to lose power after failing to do so. Inflation has been declared Public Enemy No. 1 many a time.

While the mantra from Frankfurt and Brussels has been that the current price rises are temporary and caused by pandemic-related supply and demand issues, there’s been a shift in tone more recently. The other day, a senior EU official conceded the inflationary outlook could be more long term than expected. “We always expected inflation numbers to pick up this year, but the pick-up is faster than expected. We’re seeing levels we haven’t seen in a long time,” he said.

European Central Bank chief Christine Lagarde said last week that the ECB is “very unlikely” to raise interest rates next year, pushing back on market expectations that an increase could come in October. But as Bloomberg has reported, a rift is opening within the ECB over how rapidly monetary policy should respond to stubbornly high inflation.

ECB Vice President Luis de Guindos still thinks that inflation will slow next year but he concedes that “the intensity and speed of the decline may not be what we expected a few months ago.” Some national Central Bank Governors are reportedly keener to act sooner rather than later, if necessary.

The Government has adopted a prudent approach, with a reduction on the excise tax on fuel.

According to Politico, criticism of the ECB’s lax monetary policy is growing louder again in Germany. In fact, Christian Lindner, contender for the post of finance minister in the next government, last week said he was worried about the ECB’s purchasing of bonds. “The fact that the ECB seems to be acting differently than the [U.S. Federal Reserve] at the moment may unfortunately underpin my fear.”

A key driver of inflation is the ongoing surge in energy prices. Initially, the majority view was that the current trend is a temporary blip. But French President Emmanuel Macron has warned his fellow leaders that energy prices will not fall anytime soon. The view that they will continue to rise is beginning to gain ground.

What can the Maltese Government do?

Monetary interventions, such as raising interest rates or changing exchange rates are the ECB’s domain and therefore not available as a tool. Fiscal interventions to discourage consumption would be unpopular and would depress the domestic demand upon which retailers are relying to go back to normal. On the other hand, fuel prices may be fixed directly by the government to prevent higher prices for electricity from the interconnector or for gas imports from passing through. Such administrative price-setting measures will, however, result in the government accruing large subsidy bills, with an unwelcome negative impact on the fiscal balance.

The situation is difficult. Because, if high price increases are followed by wage demands, which try to compensate for the loss of purchasing power that people experience, we would enter into a vicious circle. The Government could use changes in indirect taxation, such as VAT rates, to neutralise some of the inflationary pressures, but this too would deliver a blow to the public finances.

The Government has adopted a prudent approach, with a reduction on the excise tax on fuel. It may be the right one until the fog clears. In the next few months, it needs to engage in careful monitoring of economic developments, including any systemic inconsistency between its inflation target and actual price movements, and of specific demand-supply factors and labour market conditions. If what seem temporary factors then become entrenched drivers, a more pro-active stance will be called for.

In the meantime, the elections beckon, and surely that will complicate matters even further.

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