Only Rising Energy Supplies Could Quickly Cut Inflation

Dr Ivanovitch - MSI Global
Dr. Michael Ivanovitch

After months of implausible assertions that an accelerating inflation was a “transitory and reversible” event, the U.S. and Eurozone monetary authorities have finally recognized that increasing price pressures were stronger and more deeply rooted than they thought.

The implication of that radically revised inflation outlook is that American and euro area economies are now on a path of an inexorable growth recession.

The reason is simple and well known: The U.S. Federal Reserve (the Fed) and the European Central Bank (ECB) will have to suppress inflation by raising interest rates – a notoriously blunt tool of economic management designed to cool off excess demand in an economy operating well beyond the physical limits to its potential and noninflationary growth.

That is always a road to recession, because long and variable lags in the impact of monetary policy make it impossible to precisely calibrate the extent and the timing of credit restraint.

I shall try to explain that complicated technical issue in the simplest possible terms.

When a central bank decides to begin a process of raising interest rates, it does that with the objective of restoring the balance of demand and supply in labor and product markets – which means it wants to slow down increasing wages and prices.

Don’t fight energy inflation with interest rates

That is the beginning of difficult policy decisions based on two key forecasts: (a) the length of time it will take for an interest rate increase to hit wages and prices, and (b) the actual impact interest rate increases will have on wages and prices.

All that is based on the best possible forecast – aka “an educated guesswork” -- the central bank can make on where the economy will be at the time its credit restraint begins to work.

Please note: The most important recent forecast (i.e., the “guesswork”) of American and euro area central banks about a “transitory and reversible” inflation turned out to be totally and unforgivably wrong.

Put simply, those two central banks had no idea about the problem they were facing.

And yet, the problem was quite simple: Soaring energy costs were the key drivers of an accelerating inflation in American and euro area economies.

In the U.S., energy inflation literally exploded during 2021 to reach 27% in January 2022. And energy costs contributed 2% to the 7.5% increase in consumer prices last month.

The euro area economy experienced much greater difficulties: Its energy price inflation during the twelve months to January rose from -4.2% to 29%. As a result of that, energy now accounts for exactly one-half of the area’s 5.1% consumer price inflation.

Based on that evidence, it is simple to conclude that increasing energy supplies would be the fastest and the easiest way to stop and reverse American and euro area price inflations.

U.S. can do it; the euro area cannot

Such a policy move would also leave a greater scope for monetary policy to stabilize prices, without causing an excessive growth recession and a sharply rising unemployment.

How likely is it that the U.S. and the euro area will do that?

That should be absolutely no problem for the U.S. – the world’s largest oil and natural gas producer. At the moment, America is pumping more oil than the Saudi Arabia or Russia, two of its key energy market competitors.

One should, therefore, expect increasing energy supplies and lower prices.

But it appears that there are two problems with that. Energy producers seem reluctant to lower prices because they want to recoup losses incurred during collapsing markets in 2020. They are also riding a very strong export demand. Reportedly, last month U.S. deliveries of liquefied natural gas to Europe were higher than Russian pipeline gas supplies.

If true, the euro area is facing a serious problem of high energy prices. Its gas reserves are now estimated at a very low 32% of capacity, the Nord Stream 2 gas pipeline is caught up in a political and administrative quagmire, and the possibility of cutting Russian energy supplies are one of the key targets of threatened sanctions packages.

In view of all that, there is no immediate relief for euro area energy markets. The U.S. gas is some 30% to 40% more expensive than the Russian pipeline gas – and that’s in addition to issues of supply availability and a special infrastructure needed to handle U.S. gas deliveries.

For the monetary union, energy inflation is a fundamental problem if consumer prices are to be held in a narrow range of 0% to 2%.

Apart from that, alarmed by its inflation rate of 5.1% Germany is pressing for a speedy return to that yardstick of price stability. This time, Berlin may well prevail again at the cost of a deep recession, rising unemployment, poverty and a widening European discord.

By contrast, with ample oil and gas supplies U.S. energy prices should not be rising 27%, and the home heating oil soaring 70%. But that seems to be an incomprehensible political choice of the moment. An energy brimming America wants to fight inflation with rising interest rates, sinking economy, increasing unemployment and deteriorating public sector finances.