Inflation in Spain: Causes & Solutions

After almost a decade without inflation, many experts thought it was a phenomenon never would reach the values ​​of twenty or thirty years ago. Suddenly price increases came back and are being large and, above all, sustained over time. To realize ​​the change it has brought about, we just have to mention that the year-on-year rate of inflation in March 2021 was a meagre 1.3%. From this point on, it started to
grow. It was 2.7% in September, 4% in December and in March 2022 it reached 9.8%. After a slight decrease in April and a rise in May, in July 2022 the value of the general CPI has been 10.8%, something that had not been observed in the last thirty years, although the general index masks very uneven increases depending on which products prices are more or less volatile.

The phenomenon is not just Spanish, it happens worldwide. In the United States in June, the inflation reached 9,1%, mainly due to the effect of the increase in fuel price. In the Eurozone in the same month the value has been 8.9% for the same reasons. Therefore, inflation is a general problem in the large majority of world economies, and largely because the causes are similar, although it affects each country in different ways.

To analyze the effects of inflation and how to alleviate them, we have to distinguish between goods. The prices of unprocessed foods and fuels change a lot, are very volatile, and external events such as wars drive prices up due to supply problems. In Spain in June, prices that have risen the most are food and beverages (12.9%), housing, water and electricity (19%) and transport (19.2%). These groups are heavily dependent of the effects gas and oil prices, which are used both for heating and for public and private transportation. The same applies to agricultural products. Fossil fuel prices are very volatile and they depend very much on international markets, while in the case of food its growth is due to the increase in the prices of the raw materials with which they are produced. But there are products whose prices change less, such as leisure and culture (3.1% increase in June), health (1.1%) and education (1.2%), which are part of the Underlying inflation. Although it is somewhat lower than the general rate, the underlying inflation rate in Spain was 5.5% in June, in the United States in May was 6% and in the euro zone in June was 5,5%. Therefore, data show that in all countries we have an important problem with general inflation and also with underlying inflation. General inflation may diminish and even vanish it its underlying causes disappear, but
underlying inflation may last for a long period of time.

The structural phenomenon that explain our current inflation is that, in many goods and services, the supply has decreased, or has become more expensive, while the demand has not changed. On the one hand, the lockdowns in China have reduced its pace and rythm of production of goods, because in many cases factories can’t produce. China’s national statistics office has reported that the PMI index, which includes a survey of purchasing managers of larger companies, had a value of 49.6 points in May; the Chinese statistical considers that a value below fifty points means recession. The effect of the slowdown in production in China has been transmitted to South Korea and Japan, that buy many intermediate inputs from China. In Japan, the production of companies fell by 1.3% and similar figures are offered by South Korea. In addition, the lockdowns have considerably reduced the export activity of Chinese ports, the largest in the world; Therefore, less products arrive to Europe and the United States, as well as parts to manufacture and assemble other products, reducing the overall supply of goods and services; there are shortages in some sectors and prices increase. In some countries transport strikes worsen temporarily the situation.

On the other hand, the consequences of the invasion of Ukraine by Russia are affecting oil and gas markets and also grain markets. Russia is selling less gas and oil, and at the same time Western European sanctions on Russia’s fossil fuels exports limit the amount available on the markets. Oil can be bought in other regions of the world, but it is more expensive, and in the case of gas it is very difficult to find alternative sources of supply. In the Euro Area it is estimated that approximately 40% of the growth in prices is due to oil and gas. Finally, the blockade of the Black Sea ports through which almost all of Ukraine’s cereal production and part of Russia’s was exported, generates further shortages and increases in the prices of agricultural raw materials, which are reflected in goods such as sunflower oil and food paste.

In addition, in our country the demand for goods and services has not diminished but rather maintained or increased. The lockdowns and restrictions during COVID-19 pandemic caused the demand to drop considerably, in spite of the fact that economic agents had income to spend. Once the restrictions disappeared, this dammed up demand reappears in the markets and consumers want to buy the goods and services that they did not buy during the pandemic, so the demand bounces back. Besides that, the support measures for productive sectors, workers (ERTEs) and the self-employed during the pandemic means that disposable income was not reduced as it would have been in another crisis. This is a factor added to supply constraints to push prices even higher and keep inflation very high.

At this point we should think about the future of inflation and how long it can be high. Part of our inflation is imported and very volatile. The prices of oil and gas that we buy abroad are out of our reach and have a very heavy impact on the prices of products we consume. If they keep increasing our inflation will remain large. We cannot act directly against imported inflation, but an analysis of the facts shows that it can head down by itself. If the price of oil hits $110 a barrel and then stays there, there will be an initial acceleration in the rate of inflation, but then no further prices increase at all will occur. The same applies to gas or food prices, especially those derived from cereals. If prices fall from a very high level, the inflation would decrease considerably and it can even become negative. But what we don’t know is when the prices of the most volatile commodities are going to peak and start to go down. In April this year, those prices were expected to peak in the summer and then decline, but recent events do not point in that direction. As an example of the undergoing phenomen we can show the prices of natural gas’ futures contracts, which are an indicator of the expectations of the larger operators in the market about what is going to happen in the coming months.

In the Netherlands, the TTF market is the widest and deepest of all those that trade natural gas futures. In mid-July the price of a megawatt-hour reached 102.9 euros, when the previous price was 95.8. That price, which fluctuates gretly, was the highest in nearly two months. The price of a barrel of Brent has doubled since the beginning of the year, and now is around 100 dollars, but its sale price in September is now at 105 dollars. If these future prices hold true, oil prices will barely grow, and its effects on inflation will be very small, while gas prices may continue to have a very large effect in our inflation. Under these circumstances the key issue is the duration of the Russian invasion in Ukraine and its effects on the markets and prices, of gas, electricity and cereals of several types. The bad news is that there is radical uncertainty about the duration of the invasion and its effects on the markets. As a consequence, it is very difficult to assess which is the best course of action for the coming months.

Therefore, to make decisions, we need to know if we expect inflation to be short-lived, in which case it may not be necessary to intervene, or if we believe it will last for a long time, and in this second case, intervention is essential. In April this year, the European Central Bank forecasts were that core inflation will reach 2.6% during 2022 and 1.8% in 2023, while the expected value of headline inflation was 5%. But events have changed values ​​and forecasts. In the document “Macroeconomic Projections for the Euro Area, the European Commission states that headline inflation rate is expected to begin to decrease at the end of this year, which implies that it will remain at high values ​​(7%-8%) during the coming months, three points higher than in the previous projection. This difference highlights the very wide degree of uncertainty about the future values ​​of inflation and therefore affects the difficulty of dealing with it in the coming months. The economic policy has a difficult task ahead to be acomplished.

To reduce inflation, the European Central Bank, and those of other countries, can use monetary policy and increase interest rates. The consequence of doing so is that it makes it more expensive for companies to borrow to buy machines and installations and for consumers to borrow money for mortgages, cars or travelling. The aggregate consequence is it reduces demand in general. Acting this way, the contractionary monetary policy rebalances aggregate demand and supply. The drawback is that economic activity and economic growth slow down. The European Central Bank has raised at its meeting of 21th July the deposit rate, from 0% to 0,5%. It has also announced further increases in September if market conditions change for bad. As a consequence, the Euribor in Spain, the reference interest rate for mortgages, which was negative at the beginning of spring, has reached a positive 1% in mid-July pending the meeting of the European Central Bank on July 25. In the United States, the Federal Funds Rate was at 0.22% in March, and raised to an interval between 2,25% and 2,5% in July.

But there is a phenomenon against which the European Central Bank, and any other central bank, has not margin of manoeuver. Price increases make wages to lose purchasing power. To compensate it, the workers ask for nominal wage increases in the negotiation of labor agreements. Since wages are a very important part of production costs, when wages rise, so do the prices of goods again. This is called the wage-price spiral. If the increase in prices is maintained over time, it will be followed by an increase in wages, which in turn cause the prices of products to increase again, not because of their scarcity, but because producing them becomes more expensive. And that entails new requests and pressures to increase wages. The process may be unstopable.

The only solution for this is a voluntary income pact by which all economic agents are ready to lose something. Workers accept that their wages rise less than prices do, and therefore they lose purchasing power. In exchange, companies agree to increase prices less than their production costs’ increase, thus reducing their profit margin. If an agreement of this type occurs, price increases become smaller and smaller. Together with the contractionary effects of the rise in interest rates that reduce the demand for goods and services, the final outcome is that inflationary pressures are driven down. In the specific case of the Spanish economy, there are three large groups involved in this possible income pact. The first are the workers of private companies that have to reach a salary agreement with the companies in the coming months. The second, employees of the public sector in a very broad sense, including all administrations and public entities, whose salary increases are determined by the government, with or without consultation with the public workers unions. Thirdly, we must take into account the pensions whose revaluation is also set by the government on an annual basis, in this case there are not unions involved, but the final outcome in practice heavily depends on the political equilibrium in our country. In the case of pensions, there is a strong government statement to revalue them according to the Consumer Price Index increase at the end of 2022. If that agreement doesn’t change, pensioners will not lose purchasing power. The government’s proposal for public employees is an increase in wages lower than the CPI at the end of the year. If the proposal goes ahead, public workers will lose purchasing power and the amount of that loss will depend on the difference between CPI increase and the rise in their wages. In any case, they will lose income. In private companies, negotiation is carried out between the unions representing the workers and the employers’ organizations that represent the companies. In this moment, the negotiation has not begun yet and the concrete discussion has been postponed to September. Overall, in the Spanish case there is a potential income pact underway, both in the private and public sectors, which will not affect pensioners. Whether inflation in our country is going to be reduced or continues to be high in the future will largely depend on the details and figures of that pact.