Tuesday, May 17

Inflation: the high price to pay for Europe’s dependence on fossil fuels

In the run-up to Putin’s invasion of Ukraine, rising prices in the euro zone were receiving a great deal of political attention. Inflation reached a maximum of 5.1% in January and 5.9% in February in the euro zone, putting the ECB in the spotlight. The most critical voices in the political sphere, despite being a minority, made themselves heard more and more, calling for an increase in interest rates to curb inflation. But the ECB took a cautious approach and decided to keep interest rates low, unchanged.

In the midst of this debate, Putin invaded Ukraine. More than a month after the outbreak of the war, the latest data shows that euro zone inflation rose to 7.5% in March, with the figure reaching 9.8% in Spain. This record rate increased the pressure on the ECB to revise its monetary policy decisions. During all this time, inflation has grown abruptly due to the rise in energy prices, which explains more than 50% of the increase in consumer prices. This figure only reflects the direct impact, but energy costs have also pushed up prices in many sectors, making the overall effect larger. But that’s not all: the rise in energy prices is linked above all to fossil fuels, that is, oil and gas. The ECB has called it “fossilinflation”.

Two conclusions can be drawn from this fact. First of all, it is no coincidence that energy prices have increased even more after the Russian attack. Europe is heavily dependent on Russian gas and Putin is pricing its fossil fuel exports higher to finance his war. This means that by importing fossil fuels from Russia, Europe is not only financing Putin’s war, but also driving up the prices the EU pays.

Second, the assumption that, regardless of where inflation comes from, it should automatically lead to a tightening of monetary policy does not take into account the factors underlying inflation. A tighter monetary policy would be the correct option if the increase in prices were driven by higher demand, as is currently the case in the United States. But this is not the case in the euro area, where inflation is mainly due to higher energy supply costs.

A hypothetical rise in interest rates in the EU would not offset rising energy prices, and what is worse, if monetary policy stops being accommodative too soon, this will have a very negative impact on our economy. With war posing a serious threat to the European economy, rapid monetary tightening could cause additional negative effects in an already stressed economy: economic activity would slow further, unemployment would rise and wage growth would slow. The ECB, for now, seems determined not to repeat the mistake made in 2008 and 2011, when it tightened its monetary policy too soon when the exact opposite was needed.

Rather than raising interest rates, the proper response to rising oil and gas prices, which translates into higher bills for European citizens, is to end Europe’s heavy reliance on imported fossil fuels that have been driving prices up in general. Accelerating the energy transition by investing in energy efficiency measures and renewable energy is the most effective political solution to the current spike in inflation. This is especially important, since inflation affects low incomes more than high incomes. And that is why, in addition to a rapid ecological transition, redistributive policies and taxation are very necessary in the current context.

At the same time, the current energy crisis clearly shows that the real risk to price stability in the euro area is delaying the transition to energy sovereignty. Although there are strong arguments against raising interest rates in the current environment, this does not mean that the ECB should not contribute to the general objective of a greener energy mix. On the contrary, the ECB should be at the forefront of the energy transition, considering how much it affects its primary mandate of maintaining price stability. The current energy mix not only affects the ECB’s ability to keep prices stable due to ongoing fossil fuel-driven inflation, but also because physical risks will lead to more persistent and dramatic price pressures if we don’t stop climate change. . It follows that the ECB must act quickly, starting by greening its long-term refinancing operations and stopping buying assets that contribute to climate change and environmental degradation.

Some fear that the green transition will put more pressure on prices in general: the so-called “greenflation”. But “greenflation” has so far had a much smaller impact on end-consumer prices than “fossilinflation.” This means that it is inaccurate to claim that the ecological transition of our economies is to blame for the painful rise in energy prices.

On the other hand, if we are serious about meeting the 2030 and 2050 climate goals, a massive mobilization of green investments will be necessary. And like any extensive fiscal stimulus, this is likely to boost inflation. But there is a substantial difference between a price rise fueled by more expensive imports from Russia and the implications of Europe mobilizing resources for its energy sovereignty. The first is a pure cost: countries buy gas, burn it and it’s over. And it carries a very high geopolitical cost: economic dependence on its energy supplier, in this case an aggressive petrostate whose economic prosperity depends on inaction to reduce emissions. But if Europe invests money in green energy infrastructure that works well and is self-reliant, that is an investment and not a cost.

From the ECB’s point of view, the inflation generated by an increase in public and private spending on renewable energy is manageable with the usual monetary policy tools. It would be an inflation created by the increase in demand, for which the ECB would have the appropriate tools. The same cannot be said for high prices due to external supply shocks, which is why monetary policy seems pretty powerless at the moment. The magnitude of the impact must also be taken into account. From a price stability point of view, long-term inflation stemming from extreme weather events, resource scarcity and high energy import prices imposed by oppressive regimes abroad is a much more dramatic prospect than the temporary increase in prices during the green transition period.

Europe’s dependence on fossil fuels has been affecting its ability to protect its citizens from geopolitical threats and rising prices. What the spike in inflation and the situation in Ukraine have shown is that Europe’s dependence on fossil fuels makes it too vulnerable to unpredictable changes in the global oil and gas market, whether it be rising prices or the implication of a war in the East, which are two sides of the same coin. In both cases, it is necessary to tackle the root of the problem and not fall into the trap of short-term political responses. Raising interest rates and diversifying Europe’s gas imports are not the ultimate solution. Accelerating the energy transition is, generating more stable prices and energy security.


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