Europe’s economic activity has bounced back to pre-pandemic levels. However, the recovery also entails new challenges.

The EU economy rebounded vigorously in spring 2021 and continued riding the re-opening wave over the summer. Not only is the EU as a whole back to the pre-pandemic level of economic activity and employment in third quarter of 2021, but by 2023 it is also projected to return to the steady output path that the economy was set to follow before the pandemic, moving onto an expansionary path.

This remarkable outcome – especially when compared to the sluggish pace of recovery from the Global Financial Crisis – is a resounding endorsement of the strong and well-coordinated policy response put in place by European national governments and EU institutions.

However, the projected strong expansionary phase ahead of us is beset with persistent uncertainties and new challenges that are testing the nerves of policymakers.

Following several years of very low inflation, the strong resumption of economic activity is now accompanied by a swift rise in inflation that is exceeding expectations. This is to some extent a mechanical response to the fading out of the deflationary forces that pushed inflation down during the early stages of the crisis.

The coronavirus pandemic – as the European Commission warned from the outset – is as much a shock to supply as it is to demand. The combination of jobs and income support with containment measures that restricted consumption opportunities inevitably resulted in important changes in consumption patterns. Not only did consumption pivot from services to goods, but it also shifted within these broad categories: leisure and hospitality collapsed, delivery services boomed, demand for cars crashed, while consumer electronics accelerated. The surge in demand for some goods has been so powerful that supply has struggled to keep up, leaving behind disruptions in shipping routes, strained supply chains and shortages of raw materials, all of which are weighing on production and delivery times and adding to the above-mentioned reflationary pressures.  

Energy prices have also rebounded strongly from their pandemic lows, but in recent months they have surged well above pre-pandemic levels. After cratering in early spring of last year, oil prices are now stabilising at a relatively high level as the sudden increase in demand compounds idiosyncratic shocks that have temporarily curtailed production. Global natural gas prices have also recovered after the downward pressures in spring 2020, but over the past few months, they have seen unprecedented increases. In Europe, the wholesale price of gas has increased even more than in other regional hubs, due to reduced stocks after a cold winter, limited supply from Russia and exceptionally weak wind- and hydropower production. Tight supplies of shippable Liquefied Natural Gas (LNG) amidst rising demand from Asia have exacerbated price pressures. In turn, rising gas prices have spilled over to wholesale electricity markets.

With inflation nearing 5% and energy inflation at almost 30% in November 2021, European citizens are rightly concerned. After almost two years of struggle with the pandemic, they now have reason to fear that price increases will curtail the purchasing power of their income and accumulated savings. Inflation scares compound with mounting evidence that we have not yet turned the page of the pandemic. New waves of infections and the emergence of new variants of concern are clouding the economic outlook by prolonging some of the on-off imposition of restrictions experienced over the past two years.

Some policymakers are also increasingly nervous as the long-dormant spectre of stagflation is again rising.

In my view, these fears are overblown. The world we live in today is very different from the world of the late 1970s, when widespread wage and price indexations, oligopolistic markets, trade protectionism and inelastic supply of fossil fuels were a perfect environment for amplifying, propagating and prolonging price shocks. Three points should be kept in mind.  

First, adjustments in price levels should not be confused with self-fulfilling inflationary pressures. A return to normalcy in the level of economic activity necessarily implies a return to normalcy in price levels – even if in the short run this implies abnormally high rates of price increase. Frictions related to disruptions in global logistics, energy inflation or supply-demand imbalances add to these reflationary pressures. Even though the price of some goods and services may eventually settle at higher levels, it is difficult to see how these disruptions would cause continuous price pressures. 

Second, price volatility should not be confused with inflation. Oil prices today are still below peak prices attained in the previous decade, whereas current gas and electricity price increases follow a long period of subdued dynamics. Futures contracts suggest that the partial normalisation of prices in 2022 is expected to be just as sharp as their rise towards the end of 2021. This volatility is likely to further increase going forward, due to the unpredictable supply of energy from renewable sources. This may call for a re-organisation of markets and contracting practices so that households are sheltered from excessive price volatility, but in a world of falling demand for fossil fuels and expanding cheap renewable energy sources, the conditions for continuous build-up of energy inflationary pressures are simply not there.

Third, only a small fraction of wages is now indexed to inflation, and a non-negligible share of the workforce is still supported by job-retention schemes. This leaves little room for excessive wage demands. Recent negotiated wage increases have indeed been subdued, a sign that unions may be prioritising non-wage factors, such as job security. As the labour market tightens, wage growth is expected to pick up, but wage increases will be accompanied by offsetting productivity gains.  

So far, economic agents seem to share the assessment of inflationary pressures being largely transitory. Inflation expectations are anchored to target, and well below current readings, while sovereign yields have barely moved.

In short, borrowing the characterisation of Fabio Panetta[1], we are now experiencing Good Inflation (linked to the very strong rebound of economic activity) and Bad Inflation (due to supply-side bottlenecks), but not Ugly Inflation (occurring when above-targeted inflation de-anchors inflation expectations and becomes entrenched).

The main risk, at this juncture, is that policymakers over-react to inflationary pressures that, although longer-lasting than previously anticipated, are expected to remain transitory. Premature monetary tightening and hasty fiscal consolidation could end up doing little to put a lid on inflation, while throwing the economy back into a recession.

Instead, policymakers should further anchor expectations by committing to clear medium-term strategies. A credible implementation of Recovery and Resilience Plans (RRPs) under Next Generation EU is key. Forward guidance and a credible medium-term fiscal strategy will be important. Nimbleness and agility were appropriately displayed in the acute phase of the pandemic crisis. Full convalescence will require a steady hand and patience.

As I argued in a recent paper[2], fiscal policy should fulfil the “three Ts”: fiscal support should be Timely, Targeted and Temporary, whilst structural reforms as spelled out in the RRPs should be Feasible, Forward-looking and Fair. Add to this Draghi’s “three Ps” for monetary policy which should be Patient, Persistent and Prudent[3] (Draghi, 2019). Whilst all these recommendations were formulated just before the outbreak of the pandemic, they maintain their validity today. Together, the letters spell TFP – a fitting acronym to capture Europe’s policy predicament in the post-COVID world.

Footnotes

[1] F. Panetta (2021), “Patient monetary policy amid a rocky recovery”, speech at Sciences Po, 24 November, Paris.

[2] Republished in M. Buti (2021), The Man Inside (BUP), chapter 38.

[3] M. Draghi (2019), « Twenty years of the ECB’s monetary policy”, ECB Forum on Central Banking, Sintra, 18 June.

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