Jean Pisani-Ferry: “If inflation starts, it will be painful to get out of this cycle”

The European Central Bank (ECB) will raise interest rates to fight inflation, while the public deficit narrows slightly. Is this difference defensible?

Monetary policy is now very expansionary in light of the current conditions. The short rate is negative, while inflation is at 7.5% in the Eurozone. Even if the situation is not the same as in the US, where inflation is entrenched, it makes sense for the European Central Bank to tighten policy. The problem is that high rates do not make it possible to face imported inflation due to the high prices of energy and raw materials.

Cooling demand will have little effect in the face of a supply shock like the one we’re seeing today with the war in Ukraine and rising gas and oil prices. Moreover, this demand is fragile, surveys indicate. As long as inflation expectations do not fall, the ECB will likely be cautious in normalizing it.

As for budget policy, the usual standards should not be applied to it. Its aim is not to support aggregate demand, but mainly to counteract the negative effects of inflation on the purchasing power of households.

What if the interest rate weapon had only a limited effect on inflation?

We are facing a problem in the eurozone. There is one short-term interest rate, set by the European Central Bank, but inflation rates are very different. The gap between the countries where the price hike is the strongest and the one where the price hike is the weakest is up to 10 points. it’s huge.

If this situation continues, countries such as Spain, where inflation is close to 10%, or the Baltic states, where it is close to 15%, will face serious difficulties. And monetary policy will not be able to do anything about it. Only fiscal policy can reduce the shock. And this is what France did with the implementation of the tariff shield, which made it possible, according to INSEE, to reduce inflation by two points.

Is it a good idea to get public finances to support the fight against inflation?

It’s not orthodox, but it’s a good answer. The higher the rate of inflation, the more likely it is that wages will follow. If so, getting out of the inflation spiral will be painful and costly, in terms of economic activity and unemployment. We might also make sure it doesn’t come up, especially since the state of public finances isn’t worrisome in the short term. It is rather favorable.

To be sure, long-term interest rates have gone up since the start of the war in Ukraine, about 80 basis points on average for risk-free rates, and cross-country spreads have widened. But real rates, that is, taking inflation into account, remain negative. In the face of a looming slowdown in economic activity, and given the pressure on prices, this is not the time to focus on fiscal consolidation.

Shouldn’t governments’ response to accelerating inflation be better targeted?

In France, I do not suggest stopping the customs shield. On the other hand, it is possible to switch to dual pricing of energy prices. Each family will benefit from the same amount of energy they can buy at a given tariff to meet their basic needs. Any additional purchases will be paid at the market rate. One could even imagine that such a device would be permanent. Because we must not deceive ourselves.

We are entering a world of prolonged energy price instability.

We are entering a world of long-term energy price instability, with declining investments in fossil fuels due to the fight against global warming and investments in sustainable energies still far from the necessary level.

How is a compromise found at the national level?

The government advises organizing a social conference without delay on how the French economy will absorb the inflationary shock. Unions will demand wage increases and companies will respond that the uncertainties are too great. For this reason, in the short term, the answer should instead take the form of bonuses to all employees. In return, unions will demand a reassessment of the branch minimum, which is often lower than the minimum wage and penalizes traditional wage increases.

The current situation is very uncertain. We could face a triple recession in the coming months: in the US, Europe and China. In this case, energy prices will fall. It is therefore essential to maintain some degree of flexibility and schedule an appointment no later than one year.

Should the budget response be coordinated at the European level?

It would be better. First, this budget support prevented it from ending up indirectly in Russia’s pockets, by raising prices and consumption of hydrocarbons. Then, the response to higher inflation must be coordinated, because it affects European countries differently and their budget capacities to deal with it are also different. It is up to the European Executive to prepare this format. We can only regret that there is no sentence on this subject in the economic policy recommendations that have just been addressed to every country.

Can the European Central Bank deal with rising spreads?

The European Central Bank has announced the end of its net asset purchases and has thus deprived itself of flexibility in allocating these purchases in the event of tensions in the debt markets. There are already reinvestments of government securities that the European Central Bank acquired as part of its contingency programme, PEPP, which is nearing completion. But the amounts do not necessarily amount to risk, while PEPP did not specify the proportions of Italian debt or German securities in the new purchases.

With the Italian elections of 2023 approaching, tensions may arise in the markets, especially if the economic situation deteriorates in the meantime. In principle, countries in difficulty can request support for the European Stability Mechanism (ESM), but member states – starting with Italy – refuse to do so in order not to be stigmatized.

Except for the marked deterioration in the economic situation, the public debt-to-GDP ratio should continue to decline in the coming quarters. This should reassure investors. A severe stagflation scenario will be required for the risks to public debt to materialize.

Is the EU’s plan for the next generation of Europe up to the challenges?

The recovery plan is a temporary mechanism aimed at improving the growth potential of countries. From a legal point of view, it can be used in the event that there is a new need for non-permanent investments.

This may be the case with regard to environmental transformation and energy, but not defense spending, for example. One possibility is to allow countries whose needs have been identified and whose public finances are less concerned to use these funds. But we cannot issue joint debt without specifying how it will be repaid. We will have to define a specific recipe at the European level, which is not an easy task. Of course, we should not rush into this issue, as this is not the time to launch major initiatives, but we should not delay thinking about it.

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