“Inflation may increase in the second half”

What will the next year look like from an economic point of view?

The visibility is clearly not good. Surveys of business leaders in the euro zone show that they expect activity to slow this winter. Industrial production began to decline in the fall.

But the recession will be less deep than we feared three months ago. The worst-case scenario has been averted thanks to an almost full recovery of natural gas supplies and particularly mild weather since the beginning of autumn. The favorable factors of 2022, primarily the reopening of economies and households drawing on their savings, will no longer support activity as much.

Energy prices will remain high across the board, and while inflation may not return to its 2% target, the impact of last year’s sharp increases will begin to be felt in developed countries. Economic growth will therefore be sluggish this year, probably less than 2% globally, less than 1% in the US and close to zero in the eurozone.

Are you worried about China?

Today is a major question mark for the world economy. The end of the “Zero Covid” strategy causes an explosion in the country, but the Chinese economy is reopening. While there may be disruptions here and there in value chains in the short term, these should stop once the peak of the epidemic passes and a strong rebound in activity is expected in the second half of the year. This would certainly be good news for the world economy, except for the Europeans.

Why?

China’s liquefied natural gas (LNG) purchases fell by about 20% last year, a boon to the Europeans by allowing them to replenish stocks this winter and avoid supply disruptions.

If China’s economy recovers strongly, 2023 will be a completely different matter. Pipeline flows from Russia should remain near zero, while China’s return to the LNG market will cause prices to rise sharply. It is a good thing that Europe is getting new gasification terminals, but the new liquefaction facilities that will be commissioned in 2023 will not be enough to meet all the demand.

The autumn 2021 scenario could be repeated when the Chinese authorities, fearing energy shortages, ask for LNG supplies at “any price”.

Does this mean that inflation could rise in Europe?

Yes. In the first half of the year, inflation will fall mechanically due to the main effects on energy, as oil and natural gas prices are generally lower than a year ago.

But if energy prices rise again in the second half of the year, inflation will rise again according to the letter W. And that’s because inflation, excluding energy, will remain very high. It would then be extremely difficult for the ECB to justify rate hikes that risk slowing the economy too much.

We focus on energy production, but also grids, storage capacities, etc. All this is inflationary.

What will the future world look like for the eurozone in the long term?

To use an already used expression, one can speak of the end of abundance. The energy crisis is not a temporary epiphenomenon. This is a strong and sustainable trend. Large-scale investments in decarbonized energies, as well as fossil fuels, are still lacking. Investments in oil and gas production have indeed declined sharply in 2014 after prices fell, and then in 2020 with the pandemic. They haven’t been back since.

Therefore, energy production, but also networks, storage capacities, etc. All of this is inflationary, especially in a world of high interest rates.

So inflation will continue?

Yes. The energy transition is not the only reason for this. Demographic aging also plays a role in this direction. The vulnerabilities revealed by the pandemic and the fragmentation of the world linked to geopolitical tensions are leading to the restructuring of value chains. This was followed by a movement of inflationary industrial displacements.

Multinational companies are driven by cost-cutting strategies and just-in-time logic [juste à temps, NDLR] sustainability of value chains and the “just in case” approach [au cas où]. This forces companies to diversify or even duplicate sources of supply, increase inventories, move to “friendly” countries, etc. This is not fashion. It is a long-term, costly and inflationary phenomenon.

How will Western countries manage this inflation-resistant turn?

That’s the big question. For now, European governments have decided to temporarily and partially compensate for the decline in household purchasing power through subsidies and public transfers. This may not be the case forever due to rising public debt caused by central banks pursuing more restrictive monetary policies.

Given the current social discontent, the wage debate is unlikely to end anytime soon. In the context of high inflation and given the debt constraint, raising wages will ultimately appear to be the only solution.

In the context of social dialogue, at least partial and conditional re-indexation of wages to inflation does not seem entirely illegal.

Doesn’t this pose a risk of inflation?

That’s really the risk. But inflation is already there and probably for a long time. So we don’t really have a choice, and it would be wrong not to accept it. Therefore, an inflation target above 2% may seem desirable.

However, given the current high inflation rate, central banks cannot change their losing game rules yet. They risk losing their credibility. When inflation moderates significantly, this debate will resurface. In particular, the additional effort of central banks to reduce inflation to 2% is very costly in terms of activity and employment.

In addition, it could run counter to climate goals and jeopardize price stability, as rising interest rates would make investments more expensive.

In these new circumstances, the re-indexation of wages to the level of inflation, at least partially and tentatively based on social dialogue, does not seem entirely illegal. Especially since the evolution of income distribution over the last 30-40 years has been extremely unfavorable for workers.