Why are we talking about inflation again?

Inflation has risen appreciably in the early months of this tragically explosive year. In Europe and in Italy February saw the rate hitting nearly 6%, surprisingly higher than analysts’ expectations which were hovering just above 5%. For now, the increase is in line with projections from the European Central Bank (ECB), which at year’s end 2021 predicted a rate topping 3% for the following year. In some sense, 2022 will be a year when we lose the battle against price rises, but we already knew this would happen back in Summer 2021.

The real battle, to use a term sadly descriptive of the current international situation, will come in 2023, the year that the ECB continues to project that inflation will not exceed the 2% target. The structural motivations adopted by the ECB in December 2021 to justify this scenario can be found in a combination of considerations linked to supply and demand. On the supply side, the reasoning goes that more effective handling of the pandemic’s aftermath would enable the global value chain to deploy its deflationary effects without further interruptions to the supply chain. (This would allow an Italian artisan, for example, to go back to sourcing raw materials from Vietnam, and deliver products replete with imagination, creativity and quality to customers on time.) And again, as far as supply, the assumption is that social discipline would prevent the reactivation of large-scale wage indexation mechanisms, measures which made controlling inflation so hard to do in the 1980s. In terms of demand, on the other hand, the premise was that growth would gradually be absorbed, give producers fewer chances to leverage their pricing power.

Till now we can say that the wager made by the ECB has paid off: a cup of coffee still costs one euro in most cafés. And this is a very positive sign for all of Europe, but a vital one for Italy, which can continue to finance its national debt and remain cushioned as far as cost of debt. At the same time, the inflationary shock of 2021-2022 will serve to shrink the debt-to-GDP ratio. So we can continue with deficit spending without exploding the macroeconomic situation, exploiting the transfer of purchasing power from bond holders to society as a whole.

But there are two key questions we have to ask ourselves: What will be the impact of Russia’s invasion of Ukraine? And how will that change the prospects for the ECB’s true objective: to keep inflation at 2% in 2023?

The war in Ukraine is generating mixed but primarily inflationary effects. From one perspective, this represents a negative shock that inhibits consumer demand and investments, in turn curbing inflation. From another, the war is drying up the supply of crude oil, driving up the prices of raw materials and the cost of doing business, and spurring whoever can to adjust their sales prices accordingly (a cup of coffee might still cost one euro, but a liter of petrol costs two). The damage could be severe, and last a long time, given that the sanctions on Russia certainly can’t be eliminated in just a few weeks. All this could keep inflation high. For the ECB, the clock has started ticking faster.

One of the most serious accusations that can be levied against the central banks is that they are behind the curve. They have failed to raise rates with enough speed and substance to stop the economy from overheating. If this accusation is borne out, it will turn into a credibility crisis in no time for these institutions. Expanding the range of possible scenarios for 2023 represents a major unknown for the ECB. If it acts quickly and raises rates, the risk is accelerating stagnation at a time when the economy is already on a downslide with the risk of recession looming. And there’s another problem (an entirely European one): the national debt of all countries will become less sustainable. But acting too slowly, and if inflation breaks through the 2% threshold once again, the risk is that excessive rate hikes will be needed in the future, giving rise to the very macroeconomic problems that the ECB is trying to prevent.

So is the outlook for Europe that much darker than expected? Not necessarily. In the past Europe has risen to the challenge in times of crisis: the euro represents the realization of the dream of EU founders; European banking regulation was established to contend with the crisis triggered by the collapse of Lehman Brothers; a new interpretation of monetary policy emerged as a response to the need to do everything possible to maintain the euro; structural reforms emerged in order to overcome the fallout of the pandemic and make the best possible use of borrowed resources. And now it may be time to take further steps, for example, to ensure better management of a common defense and set up a better energy policy.

Regrettably, Putin is showing us that even in 2022, we still need to defend ourselves from aggressors; we still need to speak with one voice. What’s more, this episode reminds us all that the transition to clean energy must be clearly seen in the light of the economic needs of half a billion people. We must be aware of the fact that independence in our energy supply is also synonymous with freedom, and that to modify energy production for an entire continent, we need to plan decades into the future, not years.

A virtuous scenario means taking a step ahead, toward the United States of Europe, within the framework of reinforcing the alliance among democratic countries, and at the same time making a greater effort to be open to other ways of life from a cultural standpoint. In the Leader Series of the Executive Master in Finance at SDA Bocconi, Professor Bazoli reminded us of this, saying that the West won the war with the Soviet Union, but failed to create the conditions for recognizing diversity within the context of cooperation. He went on to clarify that to avoid building more walls, we need to respect the needs of all, staying true to our moral principles while keeping in mind that the aim is not to destroy the enemy, but to create a sustainable institutional framework that helps everyone grow and prosper in peace.