The eurozone is headed straight for stagflation

“The only function of economic forecasting is to make astrology respectable.” American economist John Galbraith was not necessarily wrong. Christine Lagarde, the president of the European Central Bank, and its chief economist, Philip Lane, know this themselves: They have had their inflation forecasts wrong, by greatly underestimating them, for a year.

Like many, one might be tempted to add, they can brandish the pretext of war in Ukraine. It is always difficult to predict the economic consequences of a geopolitical event. Moreover, three-quarters of the ECB’s forecast error can be explained by the divergence in energy prices, Christine Lagarde defended herself on Thursday.

However, the calculations were already wrong before the Covid period. But in the other direction. For several years, Frankfurt economists have overestimated how quickly inflation will return to 2%.

Generalized pressure on prices

However, the European Central Bank was forced to change its tone on Thursday. In the face of inflation of 8.1% in May over one year in the eurozone, we have had to face the facts: price increases during the year will be higher than the 5.1%, which was the European Central Bank forecast last March. “Price pressures have spread widely and intensified, and many goods and services are becoming significantly more expensive,” Christine Lagarde said during her press conference.

Now, Philip Lane’s teams are based on 6.8% inflation in 2022 in the Eurozone. This is still less than the expectations of many economists. Citi expects consumer prices to rise 7.5% this year.

Curb on activity

At the same time with this acceleration in inflation, growth slows down significantly. The European Central Bank now expects only a 2.8% increase in Eurozone GDP this year. The war in Ukraine has further disrupted global value chains after Covid. It raises energy prices, undermining the confidence of households and manufacturers. There is a curb on activity. And it will continue, because in 2023, growth will still barely be above 2% and inflation will remain well above the ECB’s 2% target. This saves her 3.5%.

Strong inflation, slow growth…Things are starting to look serious like stagflation, time like the 1970s. Also, for now, the job market is holding up pretty well. Unemployment now affects only 6.8% of the working population in the eurozone, its lowest level since 1999. If wages rise, it could trigger an inflationary spiral, a nightmare for the European Central Bank. But governments continue to support economic activity during the current downturn.

Difficulties in reducing the burden of public debt

High interest rates in the markets may cause problems for some heavily indebted countries. With budget deficits still high, debt sustainability in countries like Italy is starting to worry the markets. “Even with the continued improvement in public finances, many governments will find it difficult to stabilize the weight of public debt,” said Florence Pisani, economist at Candriam. Notably, this would be the case for Italy, Spain and France as well. In the event of a recession, tensions will be greater.

Moreover, the ECB does not rule it out completely because it presents a scenario in which the delivery of Russian gas and oil to the Eurozone is halted from the third quarter of 2022. This “would lead to the rationing of gas supplies, significantly higher commodity prices. Trade and the intensification of global value chain problems”, according to economists in Frankfurt. In this case, inflation will rise to 8% this year and growth will weaken to 1.3%. The year 2023 will be even more difficult with GDP falling 1.7% and prices continuing to rise more than 6%.

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