Inflation Monster

A few days ago Malta’s Central Bank Governor was quoted as saying that tough decisions may need to be taken to combat the “inflation monster”. I might add that tough and innovative decisions will need to be taken, not to make the situation worse for all.

Let me try to put things into context.

Last month, March 2023, was the first month, since inflation started to rise from the end of 2021 onwards, whereby the HICP inflation rate in Malta was higher than the euro area average, as shown below. It is important to understand why this is so. On the back of lower energy prices, Eurozone headline inflation dropped to 6.9% year-over-year in March from 8.5% in February, the largest decline over a month since 1991 when Eurostat started collecting data. This is because energy inflation fell from 13.7% to -0.9% in March, which is the first decline in energy inflation since February 2021.

However, with Malta’s government absorbing all the impact of high energy prices, the impact of energy inflation was not felt in Malta. Hence as one of the largest contributors to European inflation declined, we ended up with an average HICP euro area inflation rate which is now lower than Malta’s HICP inflation rate.

The ECB is however more concerned on the effect of other elements forming an economy that recent price shocks had on them. Hence the focus is on the so called core inflation. Core inflation in Europe has increased from 5.6% to 5.7% in March 2023 with services inflation increasing from 4.8% to 5% while goods inflation fell from 6.8% to 6.6%. This means that the main concern is around wage developments. Wage growth has been rising and with unemployment still at a low of 6.6%, the chances of there being upward pressure on wages remain. This could result in somewhat stickier inflation, mainly on the services side.

Labour costs in Europe, by end Q4 2022, have sky rocketed due to the tight labour market as shown below, through the labour cost index published by Eurostat.

However further below one also sees a comparison of the same labour cost index between the EU average and that of Malta. It is evident that for most of 2022 and into 2023, Malta’s labour cost index has jumped over the EU average.

Infact, if one where to have a look at the HICP Inflation rate excluding Energy & Food for Malta and the Euro area, Malta’s inflation rate excluding Energy & Food has been persistently higher than the Euro area average for the past year or so.

All this brings me to a full circle. We indeed need to take tough decisions, even in Malta, to tackle the inflation monster. In Europe, there is some form of automatic price indexation of wages in seven euro area countries (Belgium, Spain, France, Cyprus, Luxembourg, Malta and Slovenia). While none of these countries index wages fully to the headline HICP index, in most cases the national consumer price index (CPI), or a closely related broad consumer price index, is used. In Malta we use the RPI ( Retail Price Index), whereby an automatic indexation is mainly applied to a social or minimum wage.

As the ECB itself had been advocating since at least 2021, shocks to inflation can have longer-lasting effects in the presence of second-round effects and second-round effects are more likely in the presence of wage indexation. Second-round effects can occur if households and/or firms attempt to compensate the loss of real income incurred by higher inflation when setting wages and/or prices.

This means that if we keep on going ahead with providing double digit COLA wage increases we are entering a race with no winners and many losers. We would be prolonging the negative effects of inflation on our economy, eroding our competitivity whilst feeding the “inflation monster” rather than eradicating it.

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