For a longer period of time – inflation is rising: end of inflation not yet in sight

“We need to be prepared for higher inflation for a longer period of time,” said Wifo inflation expert Josef Baumgartner. It won’t remain as high as this or next year, but inflation for 2024/25 will likely “still be relatively far from the ECB’s inflation target – which is 2 percent”.

Forecasts are unlikely to hold up
According to Baumgartner, the June Wifo inflation forecasts for this year and the coming year are unlikely to hold, but will need to be revised upwards. In the June forecast, Wifo still assumed inflation of 7.8 percent for 2022 and 5.3 percent for 2023. He cannot say for sure how much higher the new estimate will be, as the forecasting process is only just beginning. On October 7, the joint economic forecast for 2022 and 2023 of the Economic Research Institute (WIFO) and the Institute for Advanced Studies (IHS) will be published.

Energy prices cause the evil
The main reason why everything is currently becoming more expensive is the rising energy prices due to high demand and insufficient supply. This is problematic because “energy is de facto everywhere,” Baumgartner said. For businesses and households there are not only direct price increases – which everyone feels in their own electricity and gas bills – but also many indirect price increases because these costs are passed on in the prices for food, goods and services.

Expand the energy supply to counteract this
According to Baumgartner, the best remedy for the high energy prices and the resulting high inflation would be to simply expand the energy supply. For Europe, this means expanding renewable energy sources – as fossil reserves are limited – and this energy system transition will take years. Meanwhile, politicians must try other means to counteract the effects of inflation.

Rising interest rates, worries about recession
A shorter way to combat inflation is to raise interest rates. The ECB has been doing this since July: the key rate was raised from zero to 1.25% in just two interest rate steps. Despite the steep climb, there is still room for improvement. Ifo economist Timo Wollmershäuser expects the central bank to raise its key interest rate to 4 percent.

Baumgartner also does not see the end of the interest rate hikes for the time being. However, the central bank is facing a difficult situation in Europe. Because in order to combat high energy prices with its instruments, it would have to raise interest rates very sharply, which reduces the demand for energy in the economy. But that also means less production, triggering a recession that also leads to more bankruptcies and higher unemployment.

The ECB must therefore try to strike a balance between controlling inflation and slowing down the economy. A recession scenario is already forecast for Germany before the winter, Austria is still on the brink, according to the Wifo expert. “If we go into recession in Europe at the end of the year, the course of rate hikes could slow down,” Baumgartner said.

Political intervention needed
It is therefore also relevant how the EU intervenes politically to curb energy prices. Several proposals will be discussed at the meeting of EU energy ministers on Friday. In addition to energy-saving plans, joint gas purchases, a maximum price for gas purchases from Russia or the skimming of excess profits from energy companies are under discussion. Detailed plans should be available by the end of September.

According to Baumgartner, it is a viable option to support suppliers in purchasing gas so that they can pass the cheaper prices on to customers. On the other hand, he thinks little of direct price controls – such as those for petrol in Hungary – as a measure against inflation. The reason is that this would reduce incentives to use less fossil fuels and that wealthier households, who could also handle inflation on their own, would receive more support than poorer households. Such an intervention would “have very negative effects on domestic supply, especially over a longer period of time, because producers in neighboring countries, where there are no price controls, can sell at higher prices,” Baumgartner says.

Reduced gas flow?
Even lifting sanctions against Russia – as some politicians are proposing – would have no effect from Baumgartner’s point of view. Because it is highly questionable whether Russia will really supply more gas again if the sanctions are lifted or relaxed. Russia is in an economic war with Europe that started before the invasion of Ukraine. Already in the summer of 2021, before the attack on Ukraine and the subsequent EU sanctions, Gazprom no longer stored anything in its gas storage facilities in Europe and thus massively limited the gas supply.