After the hard struggle in recent years to push up prices to levels healthy enough to encourage firms to make investments and boost production, the European Central Bank (ECB) is now being forced to allay concerns that inflation could get out of control over the next few months. This is because consumer prices rose an annual 2% in May. Fears of deflation have been replaced by fears of inflation.
The inflation hike comes at a time when the risks posed by COVID-19 virus mutations and the associated prolongation of containment measures continue to weigh on Euro area economic activity, especially in services, with GDP likely to have contracted again in the first quarter of this year. The further extension of lockdown measures due to rising infections in some countries will leave an imprint on activity in the second quarter, although vaccination campaigns are expected to gain traction in the coming weeks.
Inflation in the Euro area had climbed sharply in January, to the highest level in more than two years, after economies across the region started to lift coronavirus restrictions and rebounding demand aggravated supply bottlenecks. The rise in May was more than economists predicted, with energy the biggest gainer from a year ago when the region was in full lockdown. Three of the four largest Eurozone economies – Germany, Spain and Italy – all reported increases.
Apart from some short-term volatility, the projected medium-term inflation rate remains subdued amid still-weak demand and substantial slack in labour and product markets. European Commission staff projections see headline annual inflation easing back to 1.2% in 2022 and only reaching 1.4% in 2023. Similarly, core inflation is projected to rise only very gradually from 1.0% in 2021, 1.1% in 2022 and 1.3% in 2023. This pickup in inflation is based on the gradual reabsorption of slack in labour and product markets, in line with the recovery in overall demand and the fading out of the adverse temporary supply effects related to the pandemic and its containment measures.
Inflation in the Euro area had climbed sharply in January, to the highest level in more than two years, after economies across the region started to lift coronavirus restrictions.
The rise in European inflation comes in the wake of that in the United States, and has already pushed up long-term yields for European government bonds. UBS Chairman and former Bundesbank President Axel Weber says that “inflation rates are highly correlated internationally, and it is unlikely that the Eurozone could decouple from a global inflation comeback. If the recent rise in commodity prices or container shipping rates is a harbinger, then the global inflation comeback may already be underway.” But the ECB experts claim that much of the rise in European inflation is due to developments that are unlikely to be repeated.
The Federal Reserve in the United States hasn’t turned its back on the easy-money approach it adopted last year, despite the highest inflation since the 2008 financial crisis. Some high-profile critics warn, however, that bubbling inflation could instead feed on itself and force the Fed to slam on the brakes by raising interest rates. That might cool rising prices but only at the cost of plunging the United States into a new recession. The global economy would be destabilised once foreign investors and borrowers are forced to absorb punishing losses.
The Federal Reserve insists that May’s 5% annual inflation reading — the highest since August 2008 — represents a temporary fever. It is confident that the supply of goods will improve as more companies resume normal operations while consumer demand will ease as government stimulus payments taper off.
Inflation is the one word European governments really don’t want to hear right now. There’s almost nothing that could spook leaders more. Eurozone debt has risen to about 100% of economic output as a result of the massive support programmes launched during the coronavirus crisis. The figure runs even higher in some countries as governments battle to save companies and jobs. Any significant rise in interest rates would turn Europe’s debt pile into an insurmountable challenge, bringing a sovereign debt crisis on steroids that could call into question the viability of the bloc’s currency union once again.
Policy-makers have so far brushed off concerns by pointing to low servicing costs. EU Economy Commissioner Paolo Gentiloni said this month, “This is not an enormous problem nowadays with such low interest rates and the activity of the European Central Bank” (a reference to the ECB’s hoovering up debt from the markets). On Thursday, the ECB said it would continue its bond purchases to support the economy while raising its inflation forecasts for this year and next to 1.9% and 1.5%.
But a growing number of experts are now warning inflation may come back sooner than expected, risking an end to the ECB’s largesse and a problematic rise in borrowing costs. Short-term factors, such as production bottlenecks and pent-up demand on the back of the coronavirus crisis, are widely expected to drive up inflation. Some are warning that rising asset prices, massive fiscal stimulus and demographic trends will turn those temporary price increases into a more permanent trend.
Even minor moves in interest rates could result in billions of extra servicing costs to countries such as Italy, which has racked up debt close to 160% of GDP and has barely grown in the past two decades. “This is not the time to look at the debt. This will come later,” Italy’s Prime Minister and former ECB President Mario Draghi said last week. “All countries are increasing their debt. Germany, Spain, France … This is the economic politics that needs to be done today. That’s the end of it,” he said.
While the stakes are high, fiscal authorities have largely avoided discussing debt concerns in public. The widespread consensus has been to spend now and worry later. But the day of reckoning will come eventually. “It is critical to focus not only on subsidies to struggling people and businesses, but also on investments that can lay a foundation for future growth,” ECB Governing Council member Madis Müller has said.
How much time they have remains to be determined.