Stagflation in the European Union will happen if people become scared of a real decline in their incomes

Stagflation in the European Union will happen if people become scared of a real decline in their incomes

Inflation in the European Union is accelerating every month. While in February the price level in the EU-27 rose by 6.2 per cent on average year-on-year, in March it was already 7.8 per cent. A year ago, the annual inflation rate stood at 1.7 per cent and some countries (Greece) were even experiencing relatively strong deflation.

In the context of rising inflation, the risk of so-called stagflation is increasingly being discussed. Stagflation is generally perceived as a situation in which an economy experiences significantly increased inflation and at the same time economic stagnation or even contraction combined with rising unemployment.

Although, for example, the Vice-President of the European Central Bank, Luis de Guindos, said in an interview with Bloomberg that he does not see a risk of deflation this year, a significant slowdown in economic dynamism is inevitable. “It depends on how you define stagflation. If as negative GDP growth with very high inflation, then even in the worst-case scenario we don’t see stagflation,” de Guindos said.

Technically speaking, textbook stagflation probably won’t actually happen in 2022, but that increased inflation and very slow economic growth will continue next year is absolutely certain. At least this is the scenario envisaged by a number of international and national institutions, which one after another adjust the GDP growth forecasts of the European Union (or of specific member states) downwards.

For example, the International Monetary Fund predicts that in 2023 France, Italy and the United Kingdom, which until recently was an EU Member State, will be on the very edge of stagflation. The euro area as a whole will also slow down significantly. German growth is set to fall to two per cent this year, but should accelerate to 2.7 per cent next year.

That stagflation is more likely than maintaining a solid rate of economic growth has two main causes. The first is the depletion of public budgets after two years of the coronavirus pandemic. Public budgets should help the economy in bad times and build up reserves in good times. The problem, however, is that the current bad times, caused by the post-covid recovery and the war in Ukraine, came too soon after the bad times of the covid. In fact, during those times, public budgets across the European Union were literally bleeding. If they were to continue bleeding now, they would not only soon run out of money, but would fuel inflationary pressures even more.

The second reason why stagflation is a risk in the coming years is the impact of higher inflation on actual household incomes. These will fall sharply in a number of G20 countries after several decades. People will therefore most likely (and to a large extent paradoxically) save more in order to finance rising energy bills and housing in general. Consequently, household consumption expenditure will stagnate or, even worse, fall. The rapid fall in consumer confidence in the European Union, recorded in March, which remained below February’s level despite a slight recovery in April, may be a warning.

Fears of a further decline in actual incomes have not yet fully hit European households. This will only happen when they fully feel the increase in costs, especially for energy and food. Any drastic reduction in household spending, the associated fall in business activity and hence rising unemployment, in a situation of huge money supply in circulation and supply shocks due to disrupted supply chains, may not turn out well at all.

Tomas Kolomazník, analyst of BCM

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