If removed economic policy support take the edge off inflation

The euro area and many other economies allowed national deficits to increase during the COVID pandemic without any qualms. From the point of view of inflation, the tab is still open this year, but after that economic policy support will gradually fade away – unless a new crisis emerges.

The start of the year has been stronger than expected in the euro economy and based on GDP figures, the technical recession has also been avoided, at least thus far. In Q1, GDP grew by 0.1% from the previous quarter having contracted by as much in Q4. Even though recent economic figures indicate that softness lies ahead and economic surprise indices are leaning more towards the negative, there are no bigger crises on the horizon. This has turned the ship of the eurozone governments back from the waters of large national deficits to the outskirts of expenditure control. For example, in March the European Commission called on Member States to gradually start tightening their fiscal policies, since, in addition to a slightly brighter economic image, the labor market remains tight and borrowing costs have risen radically. This view is also supported by the Commission's economic forecast published a week ago that raised the forecast concerning 2023 economic growth in the EU slightly (now 1.0%, last winter 0.8%). Lower energy prices in particular were behind the forecast revision. The debt-to-GDP ratio is expected to fall to 83% in the EU and to below 90% in the eurozone in 2024.

Debt composure is sought, but we cannot really talk about economic discipline at this point as the debt level would still be higher than before the COVID pandemic if the forecast materializes. On the other hand, economic policy composure could help lower inflation rates as increasing demand in the public economy has contributed to higher inflation rates and thus increased the risk of an interest stimulus spiral. The underlying idea is that economic stimulus will increase overall demand - and ultimately price pressures - in the economy, increasing the pressure to tighten monetary policy, which was warned about last winter even by central banks.

Now it seems that public finances will stimulate inflation rates in the current year, but as shown in the graph below from TS Lombard, this impact would reduce radically already next year. If this happens, it will help silence inflation hawks and alleviate price pressures. Recent history has shown, however, that the eurozone that has been running from crisis to crisis is no longer reluctant to turn on the stimulus tap even in a coordinated fashion if the economy falters.