Madis Müller: Why is inflation so high and so different in different
euro area countries?
Speech by Mr Madis Müller, Governor of the Bank of Estonia (Eesti Pank), at the Bank
of Slovenia, Ljubljana, 3 March 2023.
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Thank you for inviting me.
I am very pleased to be back in Slovenia. Bostjan and his colleagues from Banka
Slovenije are such excellent hosts that it is always pleasure to visit your central bank.
Today my plan is to take stock of where we stand in our fight against our common
enemy, high inflation.
I will first talk briefly about the causes of the surge in inflation, both globally and in
Europe, where we should note that current inflation rates differ widely across the
member states of the euro area. Since I am in the unenviable position of representing a
country that had one the highest inflation rates in the euro area last year, I will also
explain the drivers behind the particularly fast growth in consumer prices in Estonia.
I will then discuss how high inflation impacts consumers and the public finances, how
monetary policy has responded, and how monetary, fiscal and structural policies
interact.
I will conclude by explaining why the best contribution that we as central bankers can
make to the economy is to restore price stability. This requires us to maintain our
course of monetary tightening until we are confident that inflation will be brought back to
its target in a lasting and sustainable manner.
The global and European roots of high inflation
The search for the causes of the current high inflation starts in the aftermath of the
Covid-19 pandemic. The global economy recovered fast once the pandemic ended and
the restrictions on consumption and travel were lifted. Aggregate demand in our
economies bounced back, and it was also boosted by the wide-ranging support
measures that governments and central banks offered to help companies and
households cope with the crisis. It turned out that not all companies could respond
quickly enough to this increase in demand, as some restrictions lingered and supply
chains remained fractured. This put pressure on input prices that was then passed on to
consumers.
Then Russia attacked Ukraine, and this caused energy and commodity prices, including
food prices, to increase sharply. The energy crisis hit Europe especially hard as the
European Union as a whole and many member states were heavily dependent on
Russian oil and gas. Russia weaponising energy pushed inflation up to levels not seen
since the last great oil shock in the 1970s and 80s. By October last year inflation in the
euro area had passed 10%, though inflation rates were very different across the
member states, ranging from 7% in France to above 20% in the Baltics in that month.
Inflation in Slovenia was just below the euro area average at 10.3%.
The differences between the inflation rates in the various countries of the euro area first
started to widen in 2020 when the pandemic caused stronger disinflation in countries
that have large tourism sectors. As the pandemic faded, inflation picked up most in
countries where the economy had declined less and where labour shortages were
starting to put pressure on wages. The Baltics were hit even harder by supply chain
disruptions when the war and sanctions cut off imports from Russia and prices rose.
Before the war started, gas and electricity were relatively cheaper in the Baltic countries
than they were on average in the euro area. This relatively low starting point made the
subsequent price increases larger in percentage terms.
After Russia invaded Ukraine, energy became the biggest cause of the divergence
between the headline rates of inflation in euro area countries. A range of factors have
caused this divergence, including the extent to which energy prices were regulated, and
what support measures governments chose to alleviate the energy price shock for
households and companies. Differences in the energy generation mix have also
contributed to the divergence, as have the terms of household utilities contracts. In
countries where the prices for electricity or gas are fixed for longer, it took also longer
for the increase in prices to pass on to consumers.
Let me summarise the main reasons why inflation was particularly high in Estonia,
reaching close to 20% last year. Much of the following also applies to Latvia and
Lithuania as the other two Baltic countries.
To start with, the share of energy and food in the consumer basket is still somewhat
higher in our countries than the average in the euro area. This meant that rapid rises in
the prices of energy and food in particular consequently had a bigger impact on our
inflation readings.
Compounding this, price setting has traditionally been more flexible in the Baltic region
than in other euro area countries, meaning that both rises and falls in commodity prices
are translated more swiftly to consumer prices. Administered prices are also flexible
and governments have allowed higher global energy prices to pass through quickly to
regulated prices, while governments in some other euro area countries have been more
cautious. High energy prices have also passed through to consumer prices in Estonia
particularly fast because Estonian households have generally preferred to have flexible
prices in their utility contracts. This had been a smart choice in most previous years, but
it cost us dearly in 2022. It meant that any price increases in the wholesale markets for
electricity in particular were immediately reflected in the prices paid by households. The
increases in the prices of electricity that Estonian households experienced in the first
half of last year were indeed dramatic.
A third and more general reason why inflation has been high in the Baltic countries was
that the economic impact of the pandemic was more limited in our region and the
pandemic was followed by a very strong and swift recovery. Expansionary fiscal and
monetary policies combined with strong domestic demand pressures therefore
contributed to an increase in inflation. On top of this was a change in the Estonian
pension system in the autumn of 2021 that allowed individuals to start withdrawing their
pension savings before they reached retirement age. Some of this money was used to
fund private consumption, which further increased inflationary pressures.
The substantial dispersion of inflation rates between the countries of the euro area
poses the question of how harmful these differences are in a monetary union. Obviously
there will always be differences between the structures of our economies, and so there
will always be some differences between the inflation rates in different countries. Such
differences have been around since the euro was first introduced, though for most of
the time they have been minor.
Large differences in inflation rates could however lead to problems with the smooth
functioning of a common currency area. An obvious problem is that a common
monetary policy allowing nominal interest rates to be similar in all of the euro area
countries will lead to differences in real interest rates if there are differences in inflation.
The real interest rates in countries with higher inflation might be too low, while the real
rates may be too high for countries with lower inflation. The common monetary policy
then becomes too lax for some countries and too tight for others. There may also be
possible concerns about the price competitiveness of individual countries in a monetary
union if they experience persistently higher inflation at the country level. Finally, not
every country in a monetary union will have identical economic and financial cycles, and
this can then in turn cause differences between national inflation rates. These are
wellknown challenges faced by monetary unions and the solution can only lie in the prudent
use of other economic policies by the government - that is their structural and fiscal
policies.
Inflation and consumers
When we talk about inflation, we usually mean how prices change for the average
consumer. However, the actual impact that inflation has on individual households can
vary quite a lot depending on their consumption patterns and the dynamics of the prices
of different goods and services. Households that spend a larger proportion of their
money on food are more exposed to changes in the price of food, while households that
have higher spending on housing feel inflation bite harder when energy prices rise.
Studies show that households on lower incomes are generally more exposed to the
problems caused by high inflation than those with higher incomes.
The difference between the levels of inflation experienced by different groups in society
was not that large when inflation was low, amounting to about one quarter of a
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percentage point as shown by the ECB's research . The gap between the inflation rates
for households on higher and lower incomes had widened in the euro area though to
1.9 percentage points by September 2022. Calculations for January 2023 by the Bruegel
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think tank indicate that it had reached two or three percentage points in many
European countries, and as much as five or even seven in countries where inflation was
20%. Such differences can aggravate inequality and have substantial distributional
effects. It is low-income households that face higher rates of inflation, but they typically
have smaller financial buffers and hold their savings on bank accounts with low interest
rates, which are less protected against inflation. This makes it vital that governments
target their support measures as accurately as possible.
The consequences of high inflation for public finances
High inflation also affects the public finances, as the relationship works through
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numerous channels and in both directions . Some of those channels are direct
consequences of policy measures to alleviate the impact of high inflation, especially
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higher energy prices. Bruegel estimates that countries in the European Union allocated
a total of 657 billion euros to cutting energy taxes and supporting households and firms
between September 2021 and January 2023. This amounts to 4.5 per cent of GDP for
2021, a sizeable amount of extraordinary spending indeed. Some countries have raised
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additional revenues to cover this by introducing windfall taxes on energy companies .
One positive side effect of higher inflation is that it reduces the ratio of government debt
to GDP because nominal GDP grows fast. This good news has been offset though by
the sharp rise in interest rates over the past year, and the most likely net effect is that
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interest payments on government debt will be higher in the years to come .
Inflation affects the fiscal balance through both revenues and spending and there are
both positive and negative effects. Higher inflation may bring in more tax revenue
relative to GDP if the brackets in the income tax system are left unchanged, but less
revenue relative to GDP for excise taxes that are fixed in nominal terms. Spending may
decline in relation to GDP if pensions and public sector wages adjust slowly, while
discretionary support measures of the type we have seen applied in all the EU countries
over the past year increase public spending.
It is worth noting how high inflation can affect public finances in surprising and
contradictory ways. During the first year of rising prices, the budget balance very often
improves. The higher prices first make the tax base larger and there are higher
revenues from consumption taxes, while at the same time there can be a long lag
before many costs adjust. This means there is a fiscal honeymoon in the first year of
higher prices that creates the illusion for policymakers that there is additional room in
the budget to spend. It is only during the next year or two as costs adjust and indexation
mechanisms start to work that the painful reckoning comes due. Caution is therefore
needed when any additional fiscal support measures are designed.
Ongoing research at Eesti Pank has attempted to estimate the extent to which an
unexpected rise in inflation would affect fiscal balances in the euro area using data from
the mid-1990s to 2021, and has found that inflation has a sizeable positive effect on the
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fiscal balance as a percentage of GDP . The positive effect comes both from the
expenditure side of the budget and from the revenue side. This is particularly true when
there is a significant positive inflation surprise, meaning when actual inflation turns out
to be higher than expected.
Governments in Europe increased their spending in 2022 so they could fund energy
subsidies, invest in their defence forces and provide the help needed by Ukraine.
Despite this extra spending though, the fiscal picture has remained relatively benign in
most countries and in the euro area overall. This also applies to Estonia, where
preliminary data suggest that the fiscal deficit for 2022 will be around 1.2 per cent of
GDP. This benign outcome can in large part be ascribed to the high inflation that we
saw last year. Looking ahead, this boost to public finances is likely to be reversed when
inflation comes down, at which point deficits will creep up again. This is something that
politicians should keep in mind as they plan their government's spending and taxes for
the years ahead.
The monetary policy response
Times are clearly challenging for central banks. It is difficult for monetary policy to
address supply-side shocks that are both inflationary and recessionary at the same
time. If such shocks do not last for long, it might be appropriate to wait and see whether
inflationary pressures will recede by themselves without any additional strain being put
on the economy by higher interest rates. This was not the case this time however, and
central banks were not able to just wait and let inflation spread through the economy.
Because once the inflationary mind-set has taken hold, it is very difficult to change.
Businesses and consumers must have confidence that central banks are determined to
bring inflation down to its target, even if they cannot do it overnight.
Before I discuss the latest monetary policy decisions of the Governing Council of the
ECB, let me take a brief detour into not-so-distant history. Late in autumn of 2021, we
were quite confident in the Governing Council that most of the supply-side inflation
pressures caused by the pandemic would fade by the coming spring. We expected that
economies re-opening after the Covid restrictions and historically low unemployment
would together restore healthy demand, and so it seemed reasonable to start scaling
back monetary policy support while still keeping an eye on the lingering uncertainties
hanging over from the pandemic. We decided that the pandemic emergency purchase
programme (PEPP), through which the central bank provided support to the economy
would end in March 2022. We also decided that any additional net purchases of
securities by the central bank would be scaled down gradually over the year.
These expectations were confounded though as the strict pandemic restrictions that
China applied in winter 2021-2022 and Russia's invasion of Ukraine created new
turmoil. The economy held up better than was at first feared, but inflation turned out to
be much higher and more persistent than we expected. Inflation forecasts have time
and again climbed higher, and by June there was no doubt that it was high time to
speed up the normalisation of monetary policy. We ended net asset purchases and
started to raise interest rates in July.
When we started to sketch out the policy normalisation, the financial markets did not
expect policy rates in the euro area to rise at all until 2024. Instead, we have now had to
raise interest rates in the euro area faster than ever before in the history of the
monetary union, by three percentage points in just six months. This may seem
dramatic, but we must remember where we started. Interest rates had been very low for
more than a decade, and they are still lower than they were before the global financial
crisis.
The ECB has not been alone in how it has acted. Some central banks started to
normalise their monetary policy even earlier, and the exit from the highly
accommodative monetary policy has been swifter than was expected.
Headline inflation started to come down towards the end of last year, mainly thanks to a
decline in energy prices, and it fell to 8.5% in January. More worrying however is that
core inflation has remained persistently high at more than 5%, as the underlying price
pressures are not yet receding. The ECB Governing Council consequently announced
last month that it will continue to raise interest rates and keep them high enough to
bring inflation back to its target of two per cent in the medium term. We also indicated
that we intend to raise interest rates by another 50 basis points at our next monetary
policy meeting in March. It is most likely this will not be the last rate rise in this cycle,
and it is quite possible that interest rates will need to stay high for quite some time so
that we can be sure that inflation will come back to, and remain at, close to two per cent.
Central banks need to focus on second round effects from inflation, and prevent large
but temporary price surges, like those we have seen in very volatile energy and food
prices, passing through into other prices, labour costs and inflation expectations. If they
do, they could cause a wage-price spiral, which would then stop inflation from falling
back to its medium-term target level after the temporary shocks have faded.
The interaction of monetary, fiscal and structural policies
High inflation is clearly a challenge not only for people, companies and central banks,
but also for governments. Europe has recently witnessed significant turmoil in energy
markets and governments have tried to find ways to provide relief to households and
companies either by direct subsidies or through new regulations in the energy markets.
But even before the Russian invasion of Ukraine, it was expected that the green
transition would push energy prices up. The signal given by that rise in energy prices
was intended to have an important role in encouraging the green transition. The
problem now is that not only are energy prices being steered by the green transition,
but they have also moved much more sharply because of the extreme tension in
geopolitics.
We should distinguish between two features of the current problem. The first is that
higher prices have undermined purchasing power, increased inequality and made
energy intensive industries less competitive. The second is that energy prices have
become increasingly volatile, and this in itself is a problem that policymakers need to
tackle. That the price of electricity for consumers can range between minus one cent
and 400 cents per kWh, as we have experienced in Estonia, is a concern from the
perspective of price stability. Governments are therefore facing important choices when
designing appropriate policies for the energy sector.
Looking beyond monetary policy, fiscal policy can have both a direct and an indirect
impact on inflation.
As I mentioned earlier, one of the reasons why inflation rates vary so widely between
the countries of the euro area is that countries may at any moment be at a somewhat
different point of the economic cycle. The Baltic countries for instance felt a more
limited impact from Covid-19, and their subsequent recovery was strong. The strong
cyclical position of the Baltic countries was also one of the key causes of the
acceleration in inflation. As common monetary policy cannot solve cross-country
differences in cyclical positions, fiscal policy must play a role. In countries where strong
domestic demand is causing high inflation, a tighter fiscal policy can help reduce the
pressure.
Governments also use price controls and subsidies for energy prices directly to keep
prices under control, but do so in different ways. Price controls are usually applied when
market mechanisms fail. If prices are high because markets are malfunctioning, then
price controls allow the authorities buy time to fix the mechanisms that set market
prices. But price controls cannot solve the issue of scarcity, which is often the main
cause of high prices. The main disadvantage of capping prices is that price ceilings do
not guide consumers to reduce their consumption of the scarce product. This has been
the problem with price caps for energy, as it does not encourage consumers to use
energy more efficiently, and nor do caps offer producers any incentive to increase
supply.
The alternative is targeted income support measures, which allow the burden of higher
energy costs to be shared within a society. Unlike price controls, these measures
preserve price signals and help to steer both demand and supply towards a new
equilibrium. The main concern with income support is that it is more difficult to manage.
How target groups are selected is a highly political issue and any such measures are an
additional fiscal cost, so they need to be temporary and well targeted.
In summary
Headline inflation is falling in the euro area, but it still remains too far above the ECB's
target of two per cent. That measures of underlying inflation are still very high is even
more worrisome, as it indicates a presence of more persistent inflationary forces that
can be difficult to break.
The differences in inflation rates between the member states of the euro area have
largely been driven by energy prices and the policy measures taken by governments,
and they remain wide. This may become a problem for the euro area, if such
differences become persistent and hamper the transmission of monetary policy and the
smooth functioning of the currency union. The ECB can only make monetary policy for
the euro area as a whole, without tailoring it to the needs of any particular country. This
makes it vital that such divergences in national inflation and real interest rates are kept
in check by national structural and fiscal policies.
Government support measures that are taken to shield the economy from the impact of
high and volatile energy prices must be temporary and well targeted so that they
preserve the right incentives for consumers and energy producers, and do not
overburden government finances.
In setting monetary policy, central banks must not hesitate to fight high and persistent
inflation. Keeping prices stable is the best contribution we can make to the economy,
and doing so is essential if we want to see purchasing power recover and businesses
regain the confidence to invest and create jobs. If we hesitate, we may later have to
raise interest rates much higher, and keep them high for much longer, in order to get
inflation down to its target of two per cent and to keep it there.
With this I will conclude.
Thank you for your attention, and I will be happy to answer any questions you might
have.
ECB Economic Bulletin 7/2022
2
Bruegel: Does inflation hit the poor hardest everywhere?
3
See for instance Bankowski, K., O. Bouabdallah, C. Checherita-Westphal, M. Freier,
P. Jacquinot and Philip Muggenthalerthe: "Fiscal policy and high inflation", ECB
Economic Bulletin, February 2023 .
4
See Sgaravatti, G., S. Tagliapietra, C. Trasi and G. Zachmann: "National fiscal policy
responses to the energy crisis", Bruegel Datasets, February 2023 .
5
See for instance Enarch, C.: "What European countries are doing about windfall profit
taxes", Oct. 2022 .
6
See ECB: "Eurosystem staff macroeconomic projections for the euro area", Dec. 2022 .
7
Staehr, K., O. Tkaevs and K. Urke: "Fiscal performance under inflation and inflation
surprises. Evidence from fiscal reaction functions", forthcoming working paper from
Eesti Pank.