The geopolitical and economic context as well as the resurgence of inflation challenge monetary and budgetary authorities more than it ever was for years if not decades. In this context, we publish the translation of an op-ed by Alain Grandjean, president of the “Fondation pour la Nature et l’Homme”, pointing at the risks of flawed policy decisions and suggesting some solutions to face the current challenges without endangering the overarching objective of a just transition.
The original column was published on the website of the French newspaper Le Monde. Thanks to Alain Grandjean and Le Monde for their authorization.
What to do about inflation?
The resurgence of inflation after decades of price stability rightly raises concerns about household purchasing power and financial stability. An inappropriate policy response could also jeopardise the energy transition. We propose here some leads for action to avoid these pitfalls.
The resurgence of inflation in Europe
Price increases are back in our economic landscape. At the end of March the rate of increase amounted to 5.1% in France and 7.4% on average in the euro zone, compared with 1.4% and 1.3% respectively a year ago. This increase is largely due to external causes beyond the control of governments and European central banks. It is also very uncertain whether these causes are reversible or not.
- The pressure on oil price is perennial, due to a drop in exploration and production investments since 2015 and to an inevitable reduction in oil production; it is spreading throughout the economy, particularly to raw materials and agricultural products;
- The war in Ukraine is exacerbating tensions on the hydrocarbon and agricultural product markets;
- China’s containment policy against COVID is creating blockages in factories and congestion in ports with repercussions throughout the world;
- The physical impacts of climate change are increasingly materialising in supply chains.
So far, the acceleration of inflation in the European Union has not been echoed with a widespread increase in nominal wages, and its diffusion across all prices remains limited: excluding energy and food, prices in France and the euro area had only risen by 2.4% and 3.3% respectively.
In the United States, inflation over 12 months reached 8.5% in March and its acceleration, partly induced by an expansive budgetary policy, began earlier than in Europe, even if the increase in hydrocarbon prices remains the main cause.
This imported inflation redistributes returns, mainly to the benefit of hydrocarbon producers and holders of rights to carbon assets, and to the detriment of households, particularly those most dependent on carbon-based energy, whether because of their activity, residence or income level. The fall in real income has also a negative impact on aggregate consumption and demand. Furthermore, companies are affected in different ways depending on the energy intensity of their production and their dependence on international production chains, which may push them to stop or slow down their activities.
Still a rather moderate response from monetary authorities to raising inflation.
The monetary authorities have begun to react to this inflation resurgence. The Fed announced a tightening of its monetary policy at the end of 2021, which was confirmed and reinforced at the beginning of April. The members of the Fed’s monetary committee, in their latest forecasts, expect the fed funds rate to be between 1.75 and 2% by the end of the year. The ECB has also started to react, but in a less pronounced way, by announcing the phasing out of its asset purchase programme.
The traditional response of monetary authorities against inflation is to raise interest rates. The reason for this is threefold:
- It is the most obvious way to tackle the cause of inflation when it results from excess aggregated demand over productive capacity, especially when the unemployment rate is very low
- The signal sent is also supposed to dampen inflationary expectations and « calm down » wage demands, thus breaking or avoiding the price-wage spiral
- Finally, the interest rates rise aims at limiting the losses caused by inflation to depositors and savings.
Moreover, if a powerful monetary zone such as the dollar zone raises its interest rates, other zones (in this case the euro zone) are strongly pushed to follow the trend. Lasting divergent monetary policies would inevitably lead to a fall in the parity, at the risk of amplifying the rise in import prices.
Excessively high interest rates could jeopardise the green transition.
The relative cautious response of the European monetary authorities to the acceleration of inflation, despite numerous criticisms from monetary “hawks”, is also explained by the cost of tightening their policy and by the inadequacy of a fundamentally macroeconomic instrument in a situation where the rise in prices cannot be explained by macroeconomic dynamics. However, there is a risk that they will be forced to abandon this prudence if a price-wage dynamic were to set in.
Indeed, central banks can count on the fact that a rise in key interest rates will have a simple effect on the economy: increasing the cost of credit, which reduces, all other things being equal, the capacity of borrowers, including the State and public authorities, to take out new loans or even to repay old ones.
Today, both private and public stakeholders are highly indebted. As IMF economists note, « the increase in debt is particularly marked in advanced countries, where public debt has risen from around 70% of GDP in 2007 to 124% of GDP in 2020. Private debt has grown more slowly, from 164% to 178% of GDP over the same period”. Too much of a rise in interest rates could therefore have a clear depressive macroeconomic effect and even provoke a recession, while such monetary policy would not address the root causes of price increases which are beyond its control.
Moreover, this could lead to austerity policies, the only ones being discussed in the current thinking mind-frame to contain the public deficit. It should be remembered that in France, with a public debt of € 2,800 billion, a 1-point interest rate increase costs € 28 billion, or 1.1% of GDP, to the Treasury. In practice, the effect of an interest rate rise is only seen progressively as public bond issues are made, but as France borrows 280 billion euros each year, the cost of an interest rate rise will be significantly felt, especially since, as we have seen, the rise in interest rates could be 2% or more.
A rise in rates would then lead, under the current dominant vision, to public expenditure reduction programmes. Transition investments would be strongly affected:
- Austerity programmes are, historically speaking, always « homothetic » and will not spare transition spending;
- Rising interest rates will lead private stakeholders to reduce their investments with the lowest or riskiest returns; this is generally the case for transition investments;
- This will be even more the case for households which purchasing power is being eroded by inflation and especially by the energy prices increase;
- The State will have less capacity to support their efforts and will have even less margin to install a carbon price signal without risking strong political and social opposition….
It is therefore feared that both inflation and the policy toolbox usually used against it will be highly detrimental to the green transition.
What to do about rising prices?
As we have seen, the rise in interest rates will not address the current causes of inflation, which are essentially the result of rising hydrocarbon prices and disruptions in international production chains, and not of a generalised internal pressure on productive capacities or wages. On the other hand, it could amplify the risk of a recession with no certain impact on prices and lead to stagflation.
What should be done then? Central banks are certainly independent, but hiding behind this principle will be hard for them if their path leads to a global recession and accusations of slowing down the fight against climate change. As always in a democracy, governments have the upper hand, provided they have the will and are well advised!
The first solution is to follow the example of the end of World War II by allowing inflation to reduce debt, which would help to put many situations in order.
However, this solution will be difficult to accept for:
- Most vulnerable households that are hit hard by the increase in energy prices and
- small depositors, particularly pensioners.
It would therefore be possible to combine this « solution » with targeted income increases: increases in pensions, low salaries, and social assistance (in all forms that do not encourage greater energy consumption).
The second solution is to address directly the impact and the roots of inflation: first by helping households and companies to absorb the price shock in the short term and, at the same time, by supporting their efforts to reduce their carbon energy consumption.
In this respect, it should be noted that the « solutions » generally envisaged to reduce energy dependence on Russia (shift to LNG or other suppliers) completely miss this obvious priority. We must learn some level of sobriety and at the same time accelerate the development of low-carbon energies.
Still in the short term, we could consider the use of price controls for basic necessities (energy, electricity, basic food); in particular an electricity market reform must be conducted as soon as possible. The current system does not sufficiently protect consumers from increases in the price of fossil fuels.
Finally, in the medium term, we must do everything possible to reduce our dependence on China and large-scale exports by investing massively in Europe; more than ever we need a massive plan, as ecological issues are linked to economic (purchasing power) and geopolitical issues. To this end, we need to plan for a « mobilisation economy ». For this and more than ever, we must rethink our budgetary rules.
Compliance with the Stability and Growth Pact in its current form will reinforce the need for governments to reduce public spending of all kinds. It is essential to agree on a new European governance.
The European Central Bank could also play a decisive role in this matter: instead of raising interest rates, it should resolutely and rapidly commit itself to financing investments in the transition, whether public or private, as we have been relentlessly suggesting for years!