Caps on electricity bills, fuel rebates, and cheap public transport tickets are just some of the ways European governments are trying to cushion the impact of surging energy prices.
While these policies will lower prices in the short-term, the region’s central bankers worry they risk boosting demand and forcing interest rates to go even higher in the longer term.
Tensions between governments and central banks are flaring up. There is, as Dario Perkins, an economist at research group TS Lombard, put it, “a tug of war between fiscal and monetary policy.”
“Central banks want to squeeze demand, but governments want to support incomes,” he said.
Since Russia’s invasion of Ukraine, energy prices in the region have soared. The European Central Bank has raised interest rates at an unprecedented pace in response, aiming to suppress demand to bring eurozone inflation down from its all-time highs of more than quadruple its 2 per cent target, even if it means exacerbating a potential recession this winter.
At the same time, euro area governments are promising extra fiscal support — which Allianz economists estimate has already cost taxpayers almost €500bn.
If these fiscal measures are too generous or broad-based, they will boost consumers’ spending power and undo the cooling effect on demand from higher rates — keeping inflation higher for longer in the medium term.
The EU’s plan to raise €140bn from a levy on excess profits in the energy sector to spend on measures cushioning the blow of high prices is likely to further accentuate this trend.
“The continuous fiscal efforts will make the ECB’s job much more tricky, as they will keep inflation stronger for longer, hence not getting inflation down as soon as anticipated,” said Piet Haines Christiansen, chief strategist at Danske Bank.
In the UK, tensions have reached boiling point. Chancellor Kwasi Kwarteng’s new economic strategy, which includes a £150bn energy price cap and £45bn of tax cuts funded by extra borrowing, caused a sell-off in bond markets after investors judged it would lead to more inflation and require bigger rate rises by the Bank of England.
The BoE said on Monday it would assess the plan’s impact on demand, while reminding everyone of its aim “to ensure that demand does not get ahead of supply in a way that leads to more inflation over the medium term”.
Economists have also said US president Joe Biden’s $700bn climate, health and tax bill is as likely to add to price pressure as reduce it, despite being called the Inflation Reduction Act, while his decision to forgive billions of dollars of student loans is expected to fuel more inflation.
The ECB, where fiscal policy is handled by 19 different governments, has an extra worry. Higher government debt levels may raise the spectre of a debt crisis and deter it from raising rates as high as needed to tackle inflation.
ECB president Christine Lagarde encapsulated these concerns on Monday, saying any government support should be “temporary and targeted”, which “limits the risk of fuelling inflationary pressure . . . [while] contributing to preserving debt sustainability”.
This is a new situation for Lagarde, who repeatedly praised the “strong and co-ordinated” approach of fiscal and monetary policy during the Covid-19 pandemic when both sides worked together to counter the sharp economic downturn.
Some economists doubt governments will boost demand enough to avert a sharp economic downturn, which will ease inflation. Silvia Ardagna, chief European economist at Barclays, said: “The extent of the current fiscal easing does not spare the euro area a recession and a cut in gas demand.”
The question is whether fiscal support is spread too wide and therefore boosts the spending power of people who do not really need it. “It is all about distribution,” said Jens Eisenschmidt, chief European economist at Morgan Stanley, who used to work at the ECB.
“If you are a taxi driver you probably don’t have much extra savings, but someone like me does,” said Eisenschmidt. “Yet some of these fiscal policies like fuel duty cuts help everyone and that means they can stimulate demand too much.”
