Ofelia Marín-Lozano | We started 2022 with inflation significantly higher than it had been since the 2008 financial crisis. We began to spend the savings accumulated during the pandemic, as a result of the fall in consumption due to activity restrictions. As an indication, the average American over the last ten years used to spend 93% of his or her salary each month; during the pandemic, he or she spent only 70%. Once the restrictions were lifted, he or she spent all of his or her salary and part of his or her accumulated savings. The production chains were not yet fully back to normal and the sudden increase in demand could not be fully absorbed by an increase in supply. We had an inflation of demand, thought to be limited in time and of not a very high level, which would fade away as soon as the one-off expenditure to celebrate the end of confinement was exhausted.
But in March war broke out in Ukraine. And with it came inflation due to a lack of supply of energy products, especially in a Europe highly dependent on Russian gas. Oil prices rose rapidly, to double their pre-war levels. But the real explosion of inflation was caused by the increase in gas prices, which rose tenfold in just a few months. With an auction-based electricity pricing system, like the European one, the price of gas sets the price per kilowatt hour. And suddenly, household electricity bills, which have a significant weight in the CPI, shot up. What could have been mid-single-digit inflation for a couple of quarters (that generated by a rapid expansion in demand for goods and services not immediately matched by supply), turned, after the outbreak of war in Ukraine and economic sanctions on Russia, into double-digit inflation that could last for an indeterminate period of time.
And when European citizens see the CPI rising by 10 per cent, demands for wage increases in order not to lose purchasing power become inevitable. It is difficult to accept that, if we need gas and whoever was selling it to us cheaply stops selling it to us because we go to war, and we have to buy it from someone else who sells it to us at six times the price, we are poorer. But the reality is that we are poorer. And this is where the potential problem of inflation as a self-fulfilling prophecy (known in ECB jargon as second-round effects) really begins. A long historical study of inflation allows us to observe that, beyond annual discrepancies between core (that which excludes volatile energy commodity prices) and total inflation, the one and the other converge in a multi-year perspective. And that the underlying, which is the long-term trend-setter, is fully in line with wage growth.
Put simply. This year’s wage increase sets next year’s inflation. If we raise wages to react to a rise in prices, we guarantee that prices will rise again. The worst way to fight inflation is to raise wages. But, unfortunately, this is always the first measure that citizens demand and politicians are willing to concede.
And in countries such as Spain, where half of the recipients of a stable monthly income (the sum of public employees, plus pensioners, plus subsidy recipients, equals the sum of private sector employees) have their income fixed by a political decision, wage rises for civil servants and pensioners (in themselves, and because they can condition wage bargaining in the private sector) are determinants of future inflation.
With already announced increases of 4% in public employees’ pay, and of close to 8% for pensioners, it is very likely that private sector wage increases will be at levels above 2%. And that, overall, average total compensation will rise at a rate close to mid-single digits. Very close to the rate of inflation quoted in financial markets. The rate differential paid by sovereign states between their traditional and inflation-linked bonds is close to 5% by 2023, falls to 3% by 2024 and returns to levels close to 2% between 2025 and 2032.
What can central banks do to fight inflation? In principle, raise interest rates, which they are already doing. If indebted households have to pay 3% more interest on their debts (as much as Euribor has risen in less than a year), they will have to reduce their consumption. It is true that some savers will also see a slight increase in their income (little by little, deposits will be paid back), and that bank shareholders (directly or through their participation in investment funds) will see their remuneration increase via dividends. But the net impact on consumption will be negative, in the order of 1% of total consumption, in the case of Spain.
More important, however, is the effect on public spending. In 2021, the Spanish treasury issued public debt at an average rate of 0%. In other words, borrowing was free. In fact, it was even a good deal, in terms of public accounts, since the new free debt replaced old debt at an average cost of over 1.8%, so that total interest expenditure in the budget, measured in euros, was lower in absolute terms than in the previous year, even though total debt increased. In 2023, public debt issuance to roll over maturing debt plus that needed to finance the projected deficit for the year will be around 200 billion euros. But this time at least 2.5% interest will have to be paid. Borrowing will no longer improve the state’s profit and loss account, as has happened exceptionally and against all conventional logic in recent years, but will worsen it by 5 billion euros. What would the government do with 5 billion less interest? Reduce debt? Probably not. It would most likely spend it on other things. Ultimately, on salaries paid by the public purse, contributing to the generation of inflation.
Like it or not, the ECB is increasingly the super-finance ministry of the eurozone. And by raising interest rates it will help curb inflation, because what it does is to limit the consumption capacity of indebted households. But, above all, to limit the spending capacity of the large indebted, its shareholders, the eurozone governments. Since they are in charge of fixing the income of half of the population, they are potentially the major generators of inflation.
