Is the Great Inflation Over? The 5 clues (and the risk that the recession will now arrive) – Corriere.it

This article was originally published in the Corriere della Sera newsletter Whatever It Takes, edited by Federico Fubini. Click here to register now.

I was not in Sintra, at the last Annual Forum of the European Central Bank last month. But a participant relates to me an observation that Ignazio Visco, outgoing governor of the Bank of Italy, allegedly made during the debate. Visco acknowledged that central bankers like him and others were wrong in predicting two years ago that inflation would stay under control or it would have vanished quickly. But then the governor would have asked a question: are we sure that now we are not mistaken, in an equal and opposite way, in imagining that inflation will remain higher than it should for a long time?

Visco’s question has enormous implications for workers, families, savers and the state: if central banks continue to raise rates after the summer, imagining persistent inflation, but are wrong in their prediction, would risk provoking a more severe recession than necessary, or a flare-up of financial instability, or both. There are reasons to think that the price dynamics are and will remain much more alive than before Covid: the strong public spending on investments and industrial policies in the United States and partly in Europe; demographic dynamics throughout the West, which contributes to making it more difficult for businesses to find available workers; the uncertainties and costs of decarbonisation, especially in Europe. But now I would like to focus on the less discussed forces that push in the opposite direction.

Visco’s observation in Sintra followed the presentation of a paper by an Italian scholar from Luiss, Francesco Lippi. Lippi showed that prices in Europe have risen more than expected after the shock of the pandemicwhen people resumed a normal life, so after it energy shock due to war. Pushed as if by two electric shocks, millions of companies all together decided on all the price increases they had avoided for ten years: an acceleration concentrated over time. But Lippi’s analysis shows that when inflation becomes higher than initially expected, it also tends to slow down more than initially expected. Imagine a road that suddenly climbs sharply and ends up on a plateau. This is Visco’s question: aren’t we now making our predictions wrong by excess? Out there in the real world, some clues can make him think. I list them.

The clues about the drop in inflation

– China, the world’s second largest economy, is on the verge of deflation. The causes are partly reminiscent of those that have cooled the Japanese economy for two decades, above all the slowness with which China is recovering from its real estate crisis. But the bottom line is that the world’s largest exporter of goods, with a market share of more than 15%, is exporting disinflation to its Western customers. That is us.

– In the United States, inflation in June fell from 4% annualized the previous month to slightly below 3%. A year ago it was slightly above 9%. Above all, “core” inflation (excluding unstable prices such as energy and food) has fallen below 2%. There will still be rebounds and uncertainty, but a steady trend is visible despite the full employment status.

– By the way, I note that in the average of the 38 advanced democracies of the OECD, inflation has been declining for eight months (from 10.7% to 7.7%) even though the unemployment rate in the OECD has just reached its lowest point in history. Therefore, high employment does not inexorably condemn the acceleration of prices.

– As for the euro area, the manufacturing sector has been in a serious recession for months, Germany is showing little sign of recovering from last winter’s mild recession and now the services sector is also losing steam. Disinflation is evident here too. Furthermore, fiscal policies will become more restrictive in the next six to twelve months (since the European rules come back into force) further holding back the economy.

– Finally, the raw materials from which this inflationary shock started are much cheaper today than a year ago. In essence, today they are reducing inflation rates and not the other way around. Natural gas costs 83% less than a year ago, coal 69% less, Brent oil 16.6% less, lithium (used in electric batteries) 35% less. A basic fertilizer such as urea is now 46% cheaper than a year ago, while wheat and corn are 17% cheaper. In short, the shock on raw materials is over for now and the effect on prices works in the opposite direction.

Central banks and the risk of recession

Does all of this mean that central banks are wrong in their intention to keep raising rates? It’s too early to tell. Inflation is likely to go back down to 3% in the euro area as well, but the factors that are pushing price dynamics upwards today prevent a further drop towards 2%. And this is the goal that both the ECB and the Federal Reserve are aiming for. It is not for nothing that Bruno Le Maire, the French economy minister who rarely speaks at random, said a few days ago in Aix-en-Provence: a debate on the increase in the inflation targets of central banks is “welcome”. His fear – it is clear – is that the ECB will suffocate the economy in Europe in order to bring the dynamics of prices back from 3% to 2%.

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