Fighting inflation should not just fall upon the ECB

Trade and Economics - August 1, 2022

The Federal Reserve has just gone for another interest rate hike of 75 basis points, the fourth since the start of the year, in response to rising inflation, which reached a 40-year record in June at 9.1%. While numbers may, on the surface, look similar to those we have been experiencing in Europe, US inflation has been driven by different dynamics, reflecting domestic factors more than external ones. Against this backdrop, markets predict further tightening for the coming months, followed by rate cuts next year spurred by a contracting economy. Indeed, the U.S. economy contracted for two quarters in a row in the first half of the year meeting, at first glance, the definition of a technical recession.

Turning to this side of the Atlantic, the ECB went for an increase of 50bp in July, the first since 2011, ending the era of negative interest rates begun in 2014. After underestimating the level of inflation and its persistence since last summer, the ECB now finds itself in a potentially awkward situation: it will probably force a recession to fight inflationary pressures that originated elsewhere – namely, supply bottlenecks and the energy crisis – to safeguard price stability.

That said, it would be a terrible mistake if fighting the current inflationary outlook in the Eurozone were to fall to the ECB exclusively. It would mean even higher rates – and thus less investments – with jobs lost, especially among the most vulnerable groups of workers. Indeed, this is what happens when inflation is fought through compression in aggregate demand; on the other hand, if prices rise, policymakers could expand supply so as to mitigate inflationary pressures. True, it takes some time to do so, but higher energy prices are here to stay. So, too, are geopolitical tensions, and, with those, supply bottlenecks and value chain disruptions.

I don’t mean to suggest that money should be taken from the average European taxpayer through higher taxes so as to further reduce their spending power. Rather, I refer to the even more compelling need to pursue growth policies, for instance, by ensuring that: i) the massive investment outlays funded in response to the outbreak of the pandemic – mostly under the NextGenerationEU – progress without delay so as to increase both supply and potential growth; ii) energy policy is overhauled by setting more realistic targets for decarbonization in line with the new geopolitical reality in which we find ourselves; iii) competition laws and regulations are enacted especially vis-à-vis large corporations, not just small businesses.

The above priorities, albeit simply-sketched, would be highly consistent with conservative views in Europe. According to a recent survey, citizens whose views align with ECR, highly value the Single Market and the economic opportunities that come with it. Addressing the not so transitory inflationary pressures with a growth-centered agenda would mitigate inflation while creating a more prosperous EU to the benefit of all.