The increase in energy prices is like a tax increase. Central banks were looking for inflation, but not in these circumstances.

The increase in energy prices is like a tax increase.  Central banks were looking for inflation, but not in these circumstances.

The increase in energy prices is like a tax increase. Central banks were looking for inflation, but not in these circumstances.

Consequences for monetary policy of the energy crisis

The strong increase in gas and electricity in Europe raises fears of its possible impact on inflation. In fact, the central banks of all Europe will closely follow the evolution of the situation and will prepare their speech contemplating higher inflation for next year.

Everything seems to indicate that the energy price crisis will be temporary by nature, but there is a risk of further spillovers as most economies are currently facing significant supply constraints.

In our opinion, the rise in energy prices should be treated as a tax hike. Most energy is imported, so any extra money spent will come from national economies. And since energy demand is price inelastic, households will likely see their purchasing power for other goods and services fall, ultimately proving deflationary for the rest of the economy.

When the labor market is tight, there is the risk of additional wage inflation, which in turn could affect demand. However, considering that most economies have yet to see GDP return above pre-pandemic levels, let alone output gaps close, is such a significant risk a period of temporarily higher inflation?

Many businesses are just getting back to business, and most have been forced to take out more loans to stay afloat during the pandemic. For manufacturers facing international competition (remember this is a very European problem), raising prices will inevitably mean a loss of competitiveness and market share. Therefore, they may decide to accept a temporary bump on its margins.

So far, members of the Governing Council of the European Central Bank (ECB) have begun to warn of the possibility of rising inflation, but have also suggested that they are willing to look through this form of temporary inflation. Although inflation expectations are picking up, both in household surveys and in market readings, they remain at reasonable levels given the movement seen so far in prices.

There is also little sign that wages are going to rise sharply and, bearing in mind that some of the big German unions did not reach agreements until Marchthe room for maneuver for large increases seems limited for now.

On the contrary, there is a clear division between the members of the monetary policy committee of the Bank of England (BoE). A number of other members hawkishled by Governor Andrew Bailey, have argued that policy should be tightened over the forecast horizon to keep inflation within the target range, and that the case for doing so has recently strengthened.

Other more pessimistic BoE members have recently argued against raising interest rates, and we suspect that most of the committee is willing to wait for more evidence of inflationary pressures elsewhere in the economy.

For now, let’s go against the consensus by assuming that UK interest rates will remain the same this year and next. Risks are clearly tilted to the upside sooner rather than later; however, we are concerned about a series of fragilities in the economy, such as the premature fiscal tightening that will begin next year.

So the ECB is likely to look ahead to this period of higher inflation, but the Bank of England seems more divided on the matter. If the markets are right, the UK should expect an imminent rate hike, with others to follow in 2022. This could be the BoE “Trichet moment”referring to ECB President Jean-Claude Trichet, who led the first of two rate hikes in 2011 following the global financial crisis, a move widely seen as a mistake, which could have triggered the subsequent sovereign debt crisis European.

It does not look like the Bank of England will do the same, as raising interest rates to hurt demand at a critical time in the post-pandemic recovery would be counterproductive, especially if supply in the economy is only temporarily constrained.

Central banks have desperately tried increase inflation since the financial crisis but not this kind of inflation.

*** Azad Zangana is an Economist and Senior Strategist for Europe at Schroders.


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