Dusseldorf “Inflation is always and everywhere a monetary phenomenon,” postulated Milton Friedman, who later won the Nobel Prize in Economics, in 1963 – and with this thesis determined the thinking and actions of all important central banks for many years later. Price stability is a prerequisite for high economic growth and can only be achieved if monetary policy is removed from the influence of politics, Friedman continued.
Friedman’s postulate has probably never been as wrong as it is today. Certainly, Fisher’s quantity equation, on which this postulate is based, is designed in such a way that it must always be true. After that, it is up to the central bank to influence the price level by controlling the money supply – monetary policy could be that simple, even if only in traditional textbooks.
In practice this is much more difficult. Prices in the euro area are currently being determined primarily by the following factors: Ongoing delivery problems for primary products from the Far East, especially China, are reducing the supply of new cars and machines, for example, which is driving up their prices.
Since the attack on Ukraine by Russia, a major energy supplier, Europe has been trying to replace cheap Russian energy with imports from other countries as quickly as possible – at any price.
The reduced Russian supply, especially of gas, coupled with a simultaneous increase in demand, is driving energy prices, which, with a short time lag, are affecting almost all end products in the form of higher production and transport costs.
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Inflation does not seem to have peaked yet
The surge in consumer prices that we are currently experiencing and the end of which is not in sight. Several large economic research institutes assume that the peak in price increases has not yet been reached. On the one hand, the high heating and electricity costs only reach end consumers with a delay due to contractual commitments.
On the other hand, the price hikes are likely to produce second-round effects, since the unions will try to push through strong wage increases in order to limit the real wage losses of their members. In view of the widespread shortage of skilled workers, employers will – grudgingly – meet the wage demands – within limits.
>> Read here: The Underrated Drama: Why U.S. and Europe Inflation Have Different Reasons
At the same time, the well-known management consultant Hermann Simon calls on companies to increase their margins in the current situation. Companies make “a big mistake if they raise their prices too late in times of inflation,” says Simon.
Inflation drives inflation
Some providers delayed price increases because they hoped to gain market share. “But that goes wrong. My advice to companies is: Increase prices faster! The price increases should not be below the inflation rate, but rather slightly above it. That also works easier in an inflation situation,” says Simon.
In short, inflation drives inflation, which brings us to the European Central Bank (ECB) and its monetary policy.
Prof. Bert Rürup is President of the Handelsblatt Research Institute (HRI) and Chief Economist of the Handelsblatt. For many years he was a member and chairman of the German Council of Economic Experts and an adviser to several federal and foreign governments. You can find out more about the work of Professor Rürup and his team at research.handelsblatt.com.
Certainly, from today’s perspective, interest rate hikes much earlier would have been advisable. The deflation that former central bank head Mario Draghi wanted to fight with his ultra-lax monetary policy was nothing more than a specter that was never seen outside the Eurotower.
Now, a stability-oriented monetary policy can only aim to steer aggregate demand. In times of high inflation, interest rate hikes can dampen this demand and thus curb inflation.
However, a restrictive monetary policy is powerless against price increases due to supply-side shortages, i.e. against what used to be called inflation. Even if the ECB now significantly raises key interest rates, inflation is not likely to fall for the time being – and above all not quickly.
If interest rates rise, the economy comes under pressure
The side effects of a restrictive monetary policy, on the other hand, are likely to become apparent quickly. Interest is the price for borrowed money, loosely: the price for buying something today and not only in the future.
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Higher interest rates therefore limit consumption and investment opportunities. If interest rates rise, the already fragile economy will come under further pressure. In addition, the states that are reaching their financial limits with the numerous aid programs against the energy price crisis have to pay higher interest rates on new debts, which limits their room for manoeuvre.
If, on the other hand, the ECB were to stand by and watch the rapid rise in prices, there was a risk that it would lose credibility. After all, its primary task is to ensure monetary stability in the euro area, and now, on the first test, it cannot afford to fail.
The strategists in the Eurotower have now realized this. After much hesitation, ECB boss Christine Lagarde admitted her mistake in quickly reaching the two percent target and announced further rate hikes.
The fuel discount brought drivers only temporary relief.
(Photo: dpa)
And fiscal policy? Formally, the national governments could refer to the ECB, which was entrusted with securing monetary stability as the most important task. In the expectation that this will not go down well with voters, governments are using billions in taxes to try to keep inflation down – not without success, but of limited duration. The temporary fuel discount and the nine-euro ticket in the summer pushed the inflation rate in Germany down by around one percentage point.
Such interventions may be popular with voters, but they override important price signals. A lower petrol price is driving demand – although this should actually be falling.
The state feeds the inflation that it wants to combat
The nine-euro ticket made mobility cheaper, although less mobility would be the right answer to the energy shortage. And the announced reduction in VAT on gas will lead to more gas being in demand.
At its core, the state, with its large-scale, socio-politically understandable aid packages, promotes the upward trend in prices whose consequences it wants to combat. Targeted income support for the needy, on the other hand, would largely prevent such effects – admittedly at the price of decoupling a large part of the voters from the apparent benefits.
>>> Read here: Bert Rürup: “We should do everything we can to ensure that the poor don’t get poorer”
The ECB also makes a mistake if it only looks at the statistically reported price index when this is artificially lowered by state intervention. Actually, she should look at an index adjusted for these effects – with the result that her policy would be more restrictive.
Contrary to what Friedman once postulated, inflation is by no means always just a monetary problem. Inflation arises and prevails whenever people start talking about inflation and believing that it exists or will happen.
Experience from the 1970s and 1980s, both in the USA and in Germany, shows that once inflation has picked up speed, it can only be reversed with massive adjustment pains.
Christine Lagarde probably imagined her task to be much easier when she took office almost two years ago. Today, their task is what is believed to be the most difficult civilian mission in Europe.
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