Fiscal policy is superior to monetary policy in reducing inflation without harminggrowth. Some arguments from Spain.

Eladio Febrero
University of Castilla-La Mancha, Spain
&
Jorge Uxó
Complutense University of Madrid, Spain

“The fall in inflation that has already been observed in Spain (and with some delay and more slowly in the rest of the Eurozone) can hardly be attributed to the rise in interest rates.”

The role of energy price increases in the evolution of inflation In Spain, as in the rest of the European countries, several supply shocks (bottlenecks related to the end of the pandemic and tensions in international energy markets) led to a rise in inflation, starting around March, 2021. In addition, the functioning of the electricity market and the war in Ukraine amplified these shocks.

The average inflation rate in Spain in 2022 was 8.3%, in line with the Eurozone. Nevertheless, it initiated a downward trend in August, and in March 2023, Spain was the economy with the second lowest annual inflation in the Eurozone (3.1% versus 6.9%). For 2023, the Bank of Spain forecasts an average inflation of 3.7% (compared with the 5.5% forecast by the ECB for the entire monetary union).

Data shows that the origin of rocketing inflation in Spain is mainly in the energy sector (as in Europe, Arce et al., 2023). Between March and October 2021, the increase in energy prices (especially electricity) accounted for more than 75% of the inflation rate, explaining nearly half of the headline inflation in 2022. Food prices have added some additional pressure with a delay of six months with respect to energy prices, due to the high price of fertilizers, the Russian invasion of Ukraine, and the high prices of electricity.

This inflationary process is mainly due to the pass-through by firms of higher costs to their prices (maintaining or increasing profit margins), while nominal wages have hardly contributed to inflation. The agreed average nominal wage growth in 2021 (1.5%) and 2022 (2.8%) have been lower than the inflation rate (3% and 8.3%). On the contrary, gross operating surplus explained 90% of GDP deflator growth last year. Therefore, there has been an unequal distribution of the effects of inflation, with employees experiencing intense losses in purchasing power.

The fall in inflation in Spain since August 2022 is entirely explained by the contribution of energy prices. This has much to do with the favourable evolution of international gas and oil prices. However, the energy component of HICP has decreased in Spain by 22% since then, while in the Eurozone, the fall has been much lower (only -2.3%), with the difference being explained by electricity prices.

Economic policies against inflation in Spain, and the effect of monetary policy

The Spanish Government has promoted a wide range of measures to reduce inflation and alleviate its consequences on the disposable income of households and the viability of companies in the most affected sectors (Uxó, 2022).

Measures to reduce inflation have focused on energy markets, mainly electricity prices: lowering indirect taxes, reducing the regulated part of the bill, and increasing discounts for vulnerable consumers. Action has also been taken to limit the pass-through of the rise in international gas prices to natural gas consumers. Other measures are oil price rebates, caps on updating housing rents (2%), cuts in collective transport prices, and VAT reductions in some foodstuffs.

The most relevant decision, however, has been the introduction of a cap on the price of gas in the wholesale electricity market. In Spain, as in many other countries, the price of electricity is ruled by the costliest producer at each moment, usually gas power stations. However, on 15 June 2022, the mechanism known as the “gas cap” or “Iberian Exception” came into force in the Spanish and Portuguese electricity markets. In short, this measure limits the price of gas that producers pay in wholesale markets for the generation of electricity, with the difference covered by the government. Further, large investments in renewable energies have contributed to reducing the role of gas-based electricity as the price-maker in the whole market.

The Spanish Government estimates that from 15 June 2022 to 31 January 2023, the gas price cap has meant savings of 5 billion euros for all final consumers of electricity (domestic consumers and SMEs as well as industrial consumers). Regarding the wholesale market, the average price from June 2022 to February 2023 stood at 127.89 €/MWh in Spain, compared to 273.23 in France, 240.48 in Germany, or 306.18 in Italy.

According to the Bank of Spain, these measures have effectively reduced inflation (by around 2.5 points in 2022). Moreover, it has also boosted GDP growth (by 1%) and alleviated the effects of higher prices for households and firms in the most affected sectors. Altomare and Giavazzi, 2023, share this view for Italy.

Other studies (Badenes, 2023 ; AIREF, 2022) also show that this effect has been relatively more important in relative terms for lower-income households because they spend proportionally more on food and energy, so their combined effect is redistributive and reduces poverty.

These positive effects of national policies against inflation stand in sharp contrast with the monetary policy stance and the impact of the interest rate hikes implemented by the ECB from July 2022 onwards, reaching 3.75% in May 2023.

Firstly, the fall in inflation that has already been observed in Spain (and with some delay and more slowly in the rest of the Eurozone) can hardly be attributed to the rise in interest rates, which, as the ECB acknowledges, affects prices with significant delays. For example, Lane (2023a) estimates that interest rate hikes may have contributed to reducing inflation by 0.2 percentage points (p.p.) in 2022, 1.2 p.p. in 2023, and 1.8 p.p. in 2024.

Secondly, the rise in the rate acts precisely by damaging economic growth (through its negative effect on consumption, investment, and even the possibilities of the authorities to deploy fiscal policies such as those they have been developing) and increasing the difficulties of households to cope with the loss of purchasing power (the latest financial stability report of the Bank of Spain estimates that if the interest rate rises to 4%, the number of households made vulnerable by their bank debt would rise by 400,000). Again, Lane reported that the expected effect of the interest hike on GDP growth will be a reduction of 1.5 percentage points on average for each year between 2022 and 2024. And the latest Bank Lending Survey published by the ECB informs about a tightening of lending conditions by banks, simultaneously with an ongoing decline of borrowing from firms and houses for the purchase of houses.

Moreover, monetary authorities do not discard additional hikes in the future (Schnabel, 2023) and ask for some fiscal restraint to offset demand-side inflationary pressure (Lane, 2023b). The argument is that core inflation is too high because of demand pressures, with profits growing faster than wages.

From the point of view of the Spanish economy, a restrictive monetary policy is undesirable: private consumption has been falling in the last two quarters (2022:Q4 and 2023:Q1), chiefly because of the loss of purchasing power caused by inflation and because savings accumulated during the pandemic are already over, but also because of rising interest rates (in Spain more than 70% of mortgage loans are made at a variable interest rate, and the ratio of mortgage loans over household disposable income was 62% at the end of 2022). Its relatively high growth rate of GDP (2.9% and 3.8% for the quarters mentioned above) rests on exports, notably tourist services. In the latest quarter, investment has also made a positive contribution to growth. A higher interest rate will contribute to further weakening private consumption and shrink the market for Spanish exports.

Conclusion

During 2021 and 2022, the Spanish authorities have deployed many fiscal and regulatory measures that have simultaneously managed to reduce inflation, maintain growth, and offset, to some extent, the effects of higher prices on household purchasing power. Although these measures have entailed higher spending or reduced government revenue equivalent to 1.7% of GDP (Gobierno de España, 2023 ), the government deficit and public debt have decreased.

The restrictive monetary policy implemented since mid-2022 by the ECB, however, not only explains less of the fall in inflation but also harms growth, aggravates the consequences for households of rising prices, and makes it more difficult for national authorities to deploy successful anti-inflation policies. Judge for yourselves!