When inflation rears its ugly head

People expect prices to continue rising this year. They feel that their wages ought to rise accordingly to protect their living standards. They must rise by even more if their happy experience of rising living standards in recent years is to continue.

Of course, the Opposition is having a field day harping on the rising cost of almost everything and how this is making everybody worse off, at a time when the Government will have to start reining in expenditure to reduce the COVID-induced rise in the public debt. And the general election beckons.

The most startling number in last December’s inflation figures in Malta was the 4.9% annual rise in the costs of food during the month. Keeping in mind that food accounts for 21.5% of the consumer basket, that pushed the overall inflation rate to 2.6% compared with December 2000.

Within that figure, housing prices (8% of the basket) were 3.3% higher, housing equipment (7% of the basket) were 2.6% up, and entertainment (10% of the basket) set you back 2.6% more. Transport costs (22% of the basket) were up more modestly, at just under 1.23%.

Highest EU inflation since 1997

It may be no consolation, but the all-items EU inflation rate in the past 12 months has been double that in Malta. December’s EU rate was the highest level of inflation since recordkeeping for the euro currency began in 1997.

Let’s put this bout of inflation into perspective. There is a side to it that is playing second fiddle to the price of cereals, transportation, and energy. It is the euro effect. The current weakness of the euro is making imports to the eurozone more expensive, and while it has some benefits for some major exporters like Germany, it penalises heavy importers like Malta.

The fall of almost 7% against the US Dollar looks likely to continue, especially now that the US Federal Reserve is about to embark on a more aggressive pace of monetary policy.

The game-changer might be if the ECB acknowledged that there is an inflation problem that needs to be tackled, by ending its experiment with Quantitative Easing and beginning the process of raising interest rates. That, however, does not look likely any time soon. The ECB remains dovish and continues to regard the current bout of inflation, although more persistent than expected, as temporary. 

December’s EU rate was the highest level of inflation since recordkeeping for the euro currency began in 1997.

Is this view consistent with the data? How high is the risk that the rise in inflation may dis-anchor expectations and threaten price stability?

The conventional view shared by central banks and others is that inflation is the product of three components. First is a cyclical component related to slack in the real economy (the Phillips curve). The second is a more volatile cyclical component related to energy prices, which is driven in part by commodity price shocks and in part by the effect these shocks have on consumer expectations. The third is the ‘trend’ component, which we can think of as the underlying inflation rate that would prevail if the cyclical components were zero.

This underlying trend component tracks firms’ and consumers’ long-term expectations, which are often determined by the central bank’s policy target. If these long-term expectations are anchored by a credible central bank target, the trend component of inflation will be stable – at the target rate. But once expectations become dis-anchored, then there is a danger that the stable equilibrium will be lost, in which case the central bank will have to intervene more and more forcefully to re-establish the credibility of the target.

From this perspective, given that central bankers view the current inflation as transitory, they presumably believe that the trend component of inflation is at the target rate – i.e. around 2% – and they expect the inflationary pressure to subside even without policy intervention. 

Although the two cyclical components – the Philipps curve and energy price disturbances – are temporary, there is always the risk that they might destabilise inflation if they disturb long-run expectations. In particular, oil shocks have historically induced surges of inflation expectations and could well dis-anchor consumers’ and price setters’ expectations.

Decline in inflation over the next 12 months?

Jasper McMahon, Lucrezia Reichlin, Giovanni Ricco (CEPR) have looked at the data through the lens of a statistical model proposed recently by Thomas Hasenzagl and others to try to understand inflation risks in the USA and the eurozone. Putting together the trend and the cyclical components, they get the model’s prediction for headline inflation.

In both the US and the euro area, the model predicts a cyclically dominated decline in headline inflation over the next 12 months. This is mainly explained by the energy cycle. Due to weaker Phillips curve pressure, the model predicts a faster decline in the US headline inflation rate than that for the euro area over the next 24 months.

Their views seem to coincide with those of the market as reflected by inflation swap rates although the swaps predict slightly higher inflation at one-year horizon for the US.

Decomposition helps interpret these forecasts. It shows that both the Federal Reserve and the ECB are right when they view current inflation as temporary, but that there are nuances in this view. In the US, a small but permanent increase is likely, and this implies a trend inflation rate of 2.75% in the next five years at least (assuming no large permanent shocks in the future). In the eurozone, trend inflation is likely to be 0.5-0.75 p.p. lower.

In the meantime, coming back to the things that catch consumers’ attention, food prices hit six-year highs in January after rising for eight consecutive months. The unwelcome return of food price pressures has put policy-makers and investors on high alert, worried what it means for inflation more broadly while economies are still reeling from the coronavirus crisis.

“Central banks will be watching the level of food prices quite carefully over the next few months because they will have to make a decision on whether to respond to this or not,” says Manik Narain, head of emerging market strategy at UBS.

The ECB’s Christine Lagarde admits that inflation has become a prominent topic in the ECB’s discussions, but says analysts were wrong if they thought the bank was going to raise interest rates as a response. Interest rates in the eurozone have been negative since 2014, a policy introduced by Lagarde’s predecessor, Mario Draghi, as a response to sluggish inflation following the European debt crisis.

Normally, when inflation grows, interest rates follow suit. Those who lend money demand higher rates to ensure they don’t lose value when borrowers pay them back in the future. For the time being, Lagarde refuses to change course and will keep negative interest rates in place to help consumers and businesses borrow money more cheaply and, in turn, maintain the momentum of the economic recovery.

In the third quarter of 2021, GDP in the eurozone grew by 3.7% compared with the same period in 2020, while the whole EU did so at a 3.9% rate. Malta notched a whopping 7.6%.

But the energy crisis threatens to derail the thriving recovery. The EU internal market operates on a marginal pricing system that links the overall cost of electricity with the price of natural gas, the source most often used to meet the total power demand.

“The energy issues are very important. We see that about half of the inflation that we are currently experiencing in Europe is caused directly by higher energy prices through both fuel prices that have hit records and, of course, through the recent surge on gas prices as well,” Bert Colijn, a senior economist at ING bank, told Euronews.

Of course, this is not something that the Opposition and the Media will tell you about. Electricity and gas prices in the EU in December were up by almost 23% year-on-year but were stationary in Malta thanks to the Government’s maligned energy policy.

Still, the Government needs to do something more in the next few weeks, and make sure that the most hard-hit people in society are helped cope with rising prices. The Minister of Finance has already said as much.

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