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  • FIC Hansraj

Europe’s Other Pandemic: Inflation

Whenever an earthquake strikes, it leaves behind the threat of aftershocks which can be devastating. A slight movement in tectonic plates can cause serious destruction. But not all shockwaves originate beneath the earth. They may not cause buildings to collapse or roads to crack, but they can still cause misery. Europe which consists of four out of the ten biggest economies in the world spent almost a whole year fighting such waves, which economists call inflation.

The Eurozone and the European Union went through an economic recession in 2022. The consumer price index in countries with the euro as their currency rose by a record 10.6%. What could be the reason for such a constant rise? The sharp rise in prices can be mainly attributed to the war in Ukraine, disrupted world trade and supply chains, and the gas and energy crisis. Europe faced an energy crisis due to its retributive cutting of 80% of Russian gas used for heating, industrial processes, and power. This caused a 15-fold increase in the wholesale price of gas and electricity, which lifted the CPI to unexpected heights.

Europe and inflation
Europe and Inflation

Merry Christmas

The last two months provided some relief to the policymakers. In the same 19 European countries that use Euro as their official currency, while the prices were at a record high at 10.6% in October, they dipped to 10.1% in the month of November and further plummeted to 9.2% in December. This fall occurred mainly due to slowed energy price growth i.e. prices which were actually the fundamental cause of European inflation increased but at a decreasing rate. The fall in gas prices can be attributed to abstinence in consumer demand and sufficient buffer of fuel in storage facilities across all of Europe, which was prepared in anticipation of the approaching winter.


The Road Ahead

Although these two months went well, the road ahead doesn’t seem easy. As per the numbers and analytics, the overall inflation has slowed down due to the fall in energy prices. Energy being a significant driver of inflation has allowed the continent to win from low global demand for gas, which was partly because of China’s zero covid policy. China’s economy began reopening and is likely to require more energy soon. Hence, gas prices might soar leading to an inflation rise. But on the other hand, covid cases in China are again on the rise which may affect the markets again. Will China spoil the party for Europe?


Keeping aside the external threats, internal conditions may add to the cause as well. Talking of the tight labour markets, wages have accelerated. Be it the increase in the minimum wages in some countries or compensation for the rising living costs, labour markets have caught worldwide attention. Trade unions are negotiating pay rises more and more assertively. For instance, in October, the German union IG Metall began warning strikes demanding an 8% wage increase for more than 4 million workers. This wage rise can have negative consequences, as further wage increases may prolong high inflation or even cause a wage-price spiral, which happens when three out of four consecutive quarters face accelerating consumer prices and rising nominal wages. This will create a prolonged loop in which inflation will lead to higher wage growth, fueling even higher inflation.


Finally, to fight the soaring energy prices which are causing an increase in people's cost of living, Europe is spending €705.5 billion on energy subsidies. The total Energy subsidies in Europe were just €184 Billion in 2021, indicating a jump of 380% in just one year. Till now European policymakers have responded by suppressing energy costs through subsidies, tax cuts and price controls, which can delay the necessary adjustments to an energy shock by reducing incentives for households and businesses to conserve energy and increase efficiency. This can ultimately result in higher global energy demand and prices. Alternative measures such as implementing energy efficiency policies, investing in renewable energy sources, and promoting conservation efforts can help address the energy cost surge in a more sustainable and long-term manner.


Fiscal policies by ECB regarding stimulating the economy through government spending and interest rate cuts over the last whole decade are questionable, as now it would overheat the economy because it has no spare production capacity. If an economy has reached its limit of output that can be produced but still grows, any further growth or stimulation of this economy would lead to inflationary pressures.


Considering such policies, the question arises that whether the war was a cause or just a trigger.


A Plausible Remedy

Policymakers worldwide should consider the risk, that fiscal policies aimed at protecting households from escalating energy costs can also act as a catalyst for inflation.


If they are too broad and long-lasting, they might fuel consumer demand all across Europe.

There are multiple signs that indicate that Europe’s economy will perform better than expected, including its relatively strong labour market. But how bad things can get if it doesn’t, still remains a question.


The risks of the hovering inflation can also encourage the Central Bank to sound resolute in its plans for higher rates. The philosophy of raising interest rates will prove to be fruitful in the long run, as long as it is kept under control. Rampant interest hikes, on the other hand, might further add to the possibility of a recession due to reduced consumer spending.


When the inflationary bars are at par with the Eiffel tower, will the continent have a gloomy picture of the future or the lights will shine brighter than the present?


References:

IEA

IMF Blog

The Economist

International Monetary Fund


Authors: Priyansh Kotiya, Madhav Bhatia

Illustration By: Prateek Verma


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