De Cos rules out that there will be second-round effects of inflation this year

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Pablo Hernández de Cos, governor of the Bank of Spain, stressed this Monday that there is still no evidence that second-round effects of inflation are taking place, although he has recommended move forward with the income agreement and promote “selective” measures and concentrated in the lowest-income households -which are the ones that suffer the most from the increase in inflation- and the companies that are most vulnerable to the rise in prices of raw materials.

“According to the information available, there is still no evidence that second-round effects are taking place, at least in a general way,” de Cos indicated in his speech at the Lecture Series Enrique Fuentes Quintanaorganized by the Royal Academy of Moral and Political Sciences.

The governor has explained that it would also be desirable avoid significant distortions on the signals provided by prices that encourage the adaptation of the economy to the energy shock. “And the measures should have a temporary nature so as not to generate an additional increase in public debt and the structural public deficit,” she insisted.

Urges to start a process of fiscal consolidation

On the other hand, the governor has pointed out that this fiscal policy action should be compatible with the start of a fiscal consolidation process, as early as 2023, in the most indebted countries or with a high structural public deficit, such as Spain, which makes it possible to reduce current fiscal vulnerabilities and increase future room for manoeuvre. “It must also be taken into account that an appropriate use of European funds from the Next Generation EU (NGEU) program can make starting this process compatible with maintaining a positive impact of fiscal policy on economic growth,” he pointed out.

Salaries in the EMU have remained moderate

Regarding the effects of the second round, the governor has explained that wages in the EMU have remained moderate. In fact, there has been a significant drop in real wages. However, its growth is gaining momentum, supported by the robust labor markets and by the effect of inflation on wage demands, factors that are expected to continue.

The governor has indicated that business margins have also remained, in general, moderate, although with great heterogeneity by country, company and sector. However, the transfer of costs to final prices has also been increasing and has been higher than previous episodes. “To the extent that current high inflation persists, the probability of these second-round effects increasing,” he warned. For this reason, he believes that it is essential that economic agents assume “as inevitable” the loss of income that implies the increase in the cost of imported raw materials.

In this sense, it advocates that, within the framework of social dialogue, the distribution of costs be agreed between companies and workers, so that all assume an aliquot part of the loss of real income, with multi-year commitments with respect to salary increases and the evolution of margins. This general agreement should make it possible to differentiate according to the different sectors and agents affected, as well as to avoid automatic indexation formulas to past inflation, and should be strengthened by also avoiding the widespread use of automatic indexation clauses in public spending.

The ability to pay has been affected

According to the governor, the combination of higher inflation and lower expected economic growth, together with the increase in interest rates, negatively affects the payment capacity of households and businesses, especially in the case of the most vulnerable segments , characterized by their low income levels, their dependence on energy and food products and, in some cases, their high level of indebtedness. For their part, the high levels of public debt after the pandemictogether with the tightening of financing conditions, suppose an element of vulnerability and limit the margin to adopt measures of fiscal expansion.

The ECB will continue to increase rates “significantly”

As Hernández de Cos has warned, a greater persistence of inflation would force further tightening of monetary policywhich would increase the vulnerability of those agents -public or private- with a less healthy economic and financial situation, and would affect, to a greater extent than anticipated, their spending levels.

And that since the Governing Council of the European Central Bank have indicated that it will be necessary to continue increasing interest rates “significantly” in the next meetings, at a sustained rate, until reaching levels that allow us to ensure that inflation will return to be on target. The latest ECB projections maintain an inflation of 2.3% in 2025, therefore, above 2%. These projections were built on the basis of the expectations that the markets had regarding the evolution of interest rates at the time of their elaboration.

“If these projections are taken as valid, reaching the inflation target would therefore require an increase in interest rates above what the market then expected“, the governor pointed out. In fact, he explained that since the last meeting of the ECB Governing Council there has been an increase in the maximum level of interest rates expected by the market of around 25 basis points, up to around of 3.4%.

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