The European Central Bank cannot ignore persistently higher inflation, because the longer it is persisting, the more it can change inflation psychology and lead to excessive wage and other cost increases in the medium term – according to Peter Praet. The former chief economist and executive board member of the ECB told növekedés.hu that later this year or at the beginning of 2023 we will see substantial slower growth in the eurozone. Such an environment is closer to stagflation, but at this stage it is only a possibility. He added, one should not have the illusion that the support policies will be with us forever. Europe is still in need of structural reforms.
How high is the risk of persistently high inflation in the USA?
That risk is much higher in the United States than in Europe. The US economy was operating at full capacity when the covid crisis arrived. During the time of covid there was a huge fiscal expansion in the United States.
Nowadays the US economy not only recovered from the crisis but it is growing above trend. There is a high pressure of aggregate demand, meanwhile there are significant supply disruptions.
Transportation costs skyrocketed and there is a shortage of goods.
As the US economy is operating at full capacity, the very high inflation pressure will stay with us for a while.
However, the supply side will react and the monetary and even fiscal policy has to tighten. Inflation will moderate in the second half of this year, but it will take longer to get inflation back at its target.
Do you expect persistently high inflation in the eurozone?
In the euro area, the economic performance of 2019 was reached only at the end of last year. So, we are still below trendline, where we would be without the covid.
We cannot speak in Europe about excess demand compared to USA.
As a consequence, from the demand side, there is no strong inflationary pressure in the eurozone.
The problem with demand is that we have experienced a big shift from services to goods. Therefore, in certain product categories we are seeing significant inflation.
On the supply side, in addition to number of bottlenecks like transportation, Europe has been hit by the energy crisis. That will have a substantial adverse impact on the real disposable income of people. In the meantime, supply chains will take time to normalize. That causes persistently higher inflation, which is a worrisome development.
The European Central Bank cannot ignore that, because the longer it is persisting, the more it can change inflation psychology and lead to excessive wage and other cost increases in the medium term. What one calls “second round effects”.
So, while in the US there is a very good case to tighten policy, in the euro area there is a case to be vigilant. There is no need for a strong tightening of monetary policy in the eurozone. We should rather talk about a normalization from a very accommodative policy stance.
What are the biggest positive and negative risks to economic growth in the eurozone? Can we get to an environment close to stagflation?
With the lingering energy crisis there is a higher risk of high and persistent inflation and lower growth. I think that already later this year or at the beginning of 2023 we will see substantial slower growth. Such an environment is indeed closer to stagflation, but at this stage it is only a possibility.
Notwithstanding, we should not forget the more structural relatively weak economic performance and weak productivity growth of the eurozone before the covid shock.
Europe is still in need of structural reforms. During the pandemic many of these reforms were postponed.
The Next Generation EU fund aims at fostering structural reforms and at promoting green climate goals. That is positive, but is it a game changer? I hope so, but it is too early to tell.
During the covid crises, we saw very big government support to the economy and the ECB also helped a lot. But one should not have the illusion that these support policies will be with us forever.
The structural problems of the eurozone remain with us. I am talking about the aging population, the need to reskill the labor force, inefficient education systems are in some countries. In addition to these there are new risks and challenges, for example of geopolitical nature.
Europe talks a lot about the need for greater “strategic autonomy”, but it must be mindful about the potential implications for the industry. They are not necessarily productivity enhancing.
In your opinion, to what extent is the potential GDP growth trajectory of the eurozone affected by the increased public debt of the member states?
It is a good question actually. Fiscal policy was very expansionary during the covid shock and is still expansionary today. Everybody agreed, governments did what was necessary to avoid a deep recession. As a result, public debt increased.
Now, governments need to rebuild fiscal capacity for future shocks.
Fiscal policy must be tightened by 2023. That will have an impact on growth. Thus, the fiscal consolidation process should be executed very carefully. Fiscal policy has to be very selective and oriented towards reforms.
Next generation EU fund is a very good idea, as it uses significant fiscal capacity at the european level to promote structural reforms. I hope that it will create a positive dynamic together with national fiscal policies. We will see…
What are the most important tasks of monetary and fiscal policy in an uncompleate monetary union, especially in light of the coronavirus?
Based on the experience of recent years we need a better combination of monetary policy and fiscal policy.
Fiscal policy has tended to be procyclical, being contractionary in economic downturns and buffers were not being built up in good times. In the euro area this has considerably complicated the task of the central bank.
In many countries the governance of fiscal policy has to be improved with a greater focus on macro stabilization and debt sustainability. Also, I think that the Euro Area needs to develop its own fiscal capacity.
The Next Generation EU is an important step and if successfully implemented could lead to such development.