Body
Headline numbers for inflation in the eurozone and the United States are roughly similar, in the 8-to-9-percent range. But behind those numbers lie important differences, with different implications for monetary policy and the fight against inflation. In short, the Federal Reserve faces a greater challenge than the European Central Bank (ECB), which will be reflected in very different interest rate paths for some time.
On inflation
Take the four main forces behind inflation:
First is labor market tightness, whether the market is overheating or underheating. The US labor market is clearly overheating. This is not the case in most of the eurozone.
Second are the price shocks, from energy to commodity prices to supply chain disruptions, and their first-round effects on inflation. For the United States, looking forward, the news is fairly good: Commodity prices are down, supply chains are being repaired, oil prices may not decline given the decision of the Organization of Petroleum Exporting Countries (OPEC) to reduce output, but they are unlikely to increase much. The news for the eurozone is clearly worse, mainly because of the price of gas—more on this below.
Third are the so-called second-round effects, how the initial price shocks feed into other prices and into nominal wages, as workers try to recover some of their lost purchasing power. Wage dynamics have been strong in the United States, increasingly contributing to underlying inflation. They have been more subdued in the eurozone.
Fourth is “de-anchoring,” i.e., how lasting inflation can make people question the credibility of monetary policy and the central bank’s commitment to return to the inflation target, potentially leading to a self-fulfilling increase in inflation. So far, the news has been good on both sides of the ocean: Long-term inflation expectations have moved very little.
How do these factors add up? In the United States, over the coming months, headline inflation may look good, but underlying inflation will remain too high, reflecting overheating and strong second-round effects. In the eurozone, headline inflation is likely to look worse, but behind the scenes, underlying inflation may be less of an issue than in the United States.
On activity
Turning from inflation to activity, there are again clear differences between the two sides of the ocean.
Despite the puzzling tension between unemployment numbers and GDP numbers, underlying demand in the United States is still strong. The combination of high underlying inflation and strong demand implies that the Fed will have to do much of the work of slowing the economy. It will not happen by itself.
In the eurozone, demand is much more likely to slow down on its own. Because the eurozone imports much of its energy, the increase in prices has led to a large decrease in purchasing power, some of which will be reflected in consumption and investment. Because COVID-related fiscal programs were smaller than in the United States, European households have smaller savings to rely on. The main issue, however, is the likely effects of reduced gas supply. These are twofold, price and rationing effects.
Reduced supply is leading to extremely high gas prices in Europe, and by implication high electricity costs. Letting households and firms face temporary but extremely high market prices would have led to dramatic liquidity issues, inefficient bankruptcies, major income distribution issues, and political unrest. To different degrees, governments have thus smoothed some of the costs through a series of fiscal measures.
The ideal tool in this case would be for each customer to be able to buy some volume of gas at a low price, with any additional demand facing market prices or something close. Finding the right volume for each customer is difficult, however. As a result, governments have typically gone for a mix of targeted transfers and tax cuts or price caps without thresholds. These actions have decreased inflation—for example, by an estimated 2 or 3 percent in France. As more countries adopt such measures, with Germany being a prime example, the effect of market prices for gas on inflation will be much less than it would have been absent these measures. But tax cuts and price caps dull incentives to save energy, and the implication is potential rationing this winter.
Rationing, and its effect on activity, is the biggest and most uncertain threat facing Europe this winter. Whether it takes place and forces cuts in production will depend on the weather, on accidents in other pipelines (recall the explosions of Nord Stream 1 and 2), on voluntary conservation measures, and on sharing of gas supply across countries. Unfortunately, while it would be better to ration gas to households and protect production, technological constraints imply that only the opposite can be done: Gas to large firms can be turned on and off, but it is nearly impossible to do the same for all small firms and households. A major source of uncertainty is therefore which firms will be rationed, and what might be the derived effects on the economy.
Although this situation is quite different from the experience during COVID, one remembers the surprisingly large effects of supply chain disruptions in that period. The fact that we know little is reflected in the very large dispersion of forecasts of growth next year, for example, -0.7 percent for Germany, according to the Organization for Economic Cooperation and Development (OECD), versus -3.5 percent, according to Deutsche Bank.
Even taking this uncertainty into account, it is safe to assume that production is likely to fall independently of monetary policy, and by implication, unemployment is likely to rise, putting downward pressure on wage inflation. The implication is that the ECB may not, in contrast to the Fed, need to further decrease demand.
On interest rates
These conclusions have direct implications for the likely dynamics of interest rates. Because of overheating and strong underlying demand, the Fed will need to keep interest rates high. My guess is that, while market expectations have largely adjusted, interest rates may increase beyond what is implied by the yield curve. The ECB, on the other hand, may not need to increase interest rates very much. Indeed, the ECB may remember increasing rates in response to energy prices in the fall of 2008, which is widely seen as a mistake, and make sure not to repeat it. Based on these trajectories and the implied interest rate differentials, the appreciation of the dollar seems justified.
Looking beyond the next few months, one may worry about two issues, which I briefly take on. Protecting workers and firms in Europe is coming at a substantial fiscal cost, on average around 2 percent of GDP; such actions are mostly going to be financed by debt, triggering investors’ worries about debt sustainability. For the moment, and on the assumption that gas and electricity prices will substantially come down within a year or so, these worries are not justified, even for countries like Italy: Because inflation is high, real interest rates on public debt are still much lower than growth rates, so debt dynamics allow for large primary deficits with little or no increase in debt ratios. If, however, gas prices remain extremely high for a much longer period, some governments will face a tough choice and may have to phase out the protection measures at high political cost.
I do not doubt that both the Fed and the ECB will make sure that inflation returns to low levels, if not to the initial target—although I also believe that they might eventually settle for a number higher than 2 percent. As this decline in inflation occurs, nominal interest rates will decrease. The issue, directly relevant for the assessment of fiscal space today, is what will happen to real interest rates. Will we be in a new regime where they remain elevated, as some believe, or will we be back to the low pre-COVID rates? My sense is that the factors that led to low real rates over the last 40 years are still present, and I expect rates to return to low levels, below growth rates. Secular stagnation issues will probably come back to the fore, with implications for both fiscal and monetary policies. We are not there yet.
