The causes for the Eurozone’s 9 percent inflation rate remain unaddressed

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BrusselsReport.eu
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By German MEP Engin Eroglu (Renew Europe, Free Voters), a member of the European Parliament’s Committee on Economic and Monetary Affairs

One year ago, when I wrote about the topic for Brussels Report, inflation in the Eurozone amounted to 3.0%. On 9 September 2021, with inflation at around 9 percent annually, the European Central Bank (ECB) decided to keep interest rates at zero:

“The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25% and -0.50% respectively (…).

This may also imply a transitory period in which inflation is moderately above target” 

The ECB thus expected inflation to rise only “moderately”, considering that inflation would only be for “a transitory period” above the target level of 2%.

The contrast with reality shows that the ECB was clearly off the mark in both of its assesments. The question now remains: Was the development a coincidence, whereby unpredictable factors arose? Or was it instead possible to anticipate that inflation would remain high?

One will always be wiser in hindsight, some may say. Therefore, hereunder, I discuss the seven “reasons why the ECB must act to counter persistently high inflation”, which I raised on Brussels Report a year ago, to what extent they have proven to be a factor in driving up Eurozone inflation and whether they still are a factor:

The first reason I cited was that energy costs would continue to rise because climate policies were going to continue to make energy more expensive. Indeed, the price of CO2 in CO2 ETS trading did continue to rise. On top of that, of course, rising energy costs were exacerbated by the unprovoked Russian war of aggression on Ukraine and the accompanying political sanctions issued by both sides.

Secondly, the trend to weigh risks more heavily in international trade has increased. “Reshoring” increases supply security in the EU, at the expense of higher prices. Also here, today’s geopolitical environment continues with a trend that was already foreseeable last year.

Thirdly, I pointed at the delayed effects of monetary expansion on asset prices. These have materialized but seem to be slowly fading. The expected effect has occurred, but it can no longer be readily extrapolated to the future. This is especially the case as markets are now pricing in higher interest rates, as long-term interest rates have risen significantly.

Fourthly, I referred to the high volume of orders and capacity backlogs in the German industry. Both must inevitably lead to higher manufacturing costs. This is exactly what has happened, with increases in manufacturing prices of almost 38% compared with the same month a year earlier (around 15.5% excluding energy sources).  The core rate, which does not take into account energy or food costs, is also up half a percentage point at 4.3% compared with the last meeting of the Governing Council of the ECB on 21 July. It should also be noted that the increase in producer prices is by no means over. After all, producer prices are considered an important early indicator for inflation developments.

A fifth reason I cited why inflation would increase were increased labour costs and a potential wage-price spiral. At least this is a risk in those EU countries where inflation-indexed automatic wage adjustment is common practice – for example, in the Netherlands or Belgium. Sooner or later, however, employees in other countries will also follow suit. So the dynamic of this spiral has only just begun, and there is no reason to believe that it will not continue to do so.

My sixth point – the ECB’s limited room to manoevre as a result of high level of government debt – became clearly evident when, even at the first signs of an ECB interest rate hike in June of this year, Italian government bonds rose significantly in return. The ECB is currently circumventing this problem by buying government bonds asymmetrically. In total, the ECB’s net purchases of Italian bonds amount to 9.8 billion euros. This apart from the question whether the ECB’s action is compatible with the “no bailout” principle and whether it withstands legal scrutiny.

A seventh reason, that higher inflation in itself could also become an additional driver, remains a fact: Inflation expectations are likely to rise, thereby driving inflation even higher.

Are the ECB’s actions too little, too late?

The European Central Bank’s decision earlier this month to hike interest rates by 0.75 percent is still not sufficient. The ECB’s slow reaction to the highest levels of inflation since the founding of the Monetary Union and the impact of the quantitative easing becomes particularly evident when comparing the ECB’s monetary policy with that of another central bank. Switzerland’s inflation rate is currently just 3.2%. That is 5.9 percentage points below the inflation rate of the Eurozone!

In sum, the reasons I cited twelve months ago for why the ECB must act to counter persistently high inflation have been proven to be accurate. They are also still the drivers for the current inflation trend. In no way has inflation proven to be “transitory”.

The unprovoked Russian war of aggression against Ukraine has exacerbated the situation. The reason why Putin’s consciously enforced inflation is so painful for the Eurozone is that the ECB has failed to counter the inflation that was already present decisively.

I can only agree with the German magazine Der Spiegel:

“It is time for the ECB to apologize for its hesitant actions. It would have been clearly more beneficial for the Eurozone and politically much more stable to raise interest rates earlier than to raise them in this crisis situation. But to regain credibility, the ECB will have no other choice.”

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