“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.” Ernest Hemingway
Inflation as a central issue in the Greek public discourse was absent for more than a decade. Indeed, in April 2022 Greece experienced a double-digit positive change in the Consumer Price Index (henceforth CPI) for the first time since January 1995. To a substantial extent, the price stability that Greece has experienced could be attributed to the integration of Greece into the European Monetary Union. This was followed by the deep recession coupled with the internal devaluation policies in the aftermath of the Great Financial Crisis. However, the pandemic and the subsequent energy crisis which was exacerbated by the Russian invasion to Ukraine reversed the existing trend and fuelled an inflation jump considerably more persistent than the initial estimates from markets and policy practitioners indicated.
In the first act of this drama, the pandemic turned consumer choices overnight from consumption of goods and services to mainly demand for goods (computers and monitors for telecommuting, cars to avoid public transportation, fitness equipment, etc.). At the same time, governments and Central Bankers responded rapidly providing the necessary liquidity, cash transfers and furlough schemes to compensate for the loss of income as a result of severe lockdowns and halt of economic activity. Concurrently, manufacturing and global supply chains were struggling to respond to the increased demand in an environment of labour shortage and severe restrictions. The semiconductor industry was among the first ones to be hit leading to acute chip shortages for cars and electronic devices; road transportation services reported a prolonged shortage of truck drivers and ports in Europe, the West Coast of the United States and Shanghai all reported significant congestion. It can easily be inferred that these factors induce considerable input cost increases for goods and depressed availability of raw materials in an environment of increased demand. The result of ‘too much money chasing too few goods’ became apparent from the beginning of 2021 when Central Banks around the world adopted the narrative of ‘transitory inflation’ that is going to ease and revert to the target of 2% as re-opening of the economy is gradually going to swift back consumer preferences from goods to services.
What is less known to the broader public is that the second act, which has energy as the main protagonist, starts long before the Russian invasion of Ukraine. Gas prices increased substantially in the second half of 2021 as economies reopened from COVID-19 lockdowns and high demand for LNG in Asia pushed down supplies and inventories across Europe. In the end, the war and the subsequent sanctions against Russia exacerbated the already gloomy outlook for energy prices while it added extra pressure to the food prices as Russia and Ukraine are amongst the largest wheat producers. Greece as a small open economy that is dependent on fossil fuel imports could not remain immune to the developments.
As the major drivers of inflation dynamics in the supply side have moderated considerably in the recent months and the world experiences late business cycle dynamics, our best guess is that we have already experienced the peak of the inflation rate. The central topic of discussion at this stage in our view lies to the extent of the pass-through to the service sector and the inflation persistence in the economy.
The components of Greek Inflation
In October, while the Eurozone experienced further acceleration in the rate of increase of the Harmonized Index of Consumer prices to the double-digit territory (10.6% YoY), Greek inflation rate decelerated to 9.5% YoY from 12.1% in September. Core inflation that excludes the volatile elements of food and energy decelerated as well to 8.4% slightly below 8.6% in September. These developments are to a substantial extent expected as a number of indices that are considered to be leading indicators for CPI such as the Producers and Import Price Index are in a declining trend since early summer 2022. What is more worrisome, however, is that the core measure of import and producer price indices that exclude Energy remain elevated in levels not consistent with the inflation target of 2%. When looking exclusively at Energy and Fuels we observe substantial de-escalation from the June peaks although the current observed rate of change remains elevated. Goods inflation showed for the first time in the last 12 months signs of deceleration, while in Services, even though the rate of change decreased from last month the trend is upward for the past year. This is not surprising as the increased energy and electricity costs gradually pass-through to the service sector.
Table 2: CPI subcomponents, Source: Hellenic Statistical Authority
The detailed analysis for the evolution of the subcomponents of Inflation, reemphasize the sequence of events described in the introduction. ‘Food and Non-alcoholic drinks’ which steadily rose in the last year and show no signs of a slowdown from September to October, in contrast to the general trend. Greece, as an open economy and net importer for food and commodities, experienced an increase in food prices, a trend observed globally and especially after the beginning of the war in Ukraine.
Inside the ‘Housing, Water, Electricity Gas & Fuels’, the severe increase we have witnessed for the last year in this subcomponent of the HICP can be attributed almost entirely to the cost of electricity and gas prices. It is not surprising then that the slowdown in the overall inflation rate we observed in October can be attributed to a large extent to the slowdown in the increase of ‘Electricity and Natural Gas’ prices. Looking at Figure 2 which shows the contributions of each component to the overall inflation rate, it is obvious that the ‘Housing, Water, Electricity Gas & Fuels’ (light blue) contributed more than half in October compared to September. Another important consideration for the ‘Housing, Water, Electricity Gas & Fuels’ subcomponent has to do with the nature of the housing contracts. Rentals lag significantly behind the general trend as they reflect housing contract prices secured during the pandemic and for this reason we need to be cautious and monitor this market closely for the developments in the newly agreed contracts. Lastly, the strong demand for holiday packages has made the inflation trend for ‘Hotel and restaurants’ move upward. The reopening theme along with the increased cost for energy that the service sector faces contribute to this direction.
Figure 2: Relative Contributions to Inflation, Source: Eurostat
Short-run Inflation forecast
Figure 3: Short-run inflation forecast, authors’ calculations
The future trajectory of the Consumer Price Index and the inflation developments affect the majority of the domestic economic actors including consumers, businesses, market participants and policy practitioners. However, a long literature supports the argument that short-run inflation dynamics are particularly challenging to be forecasted with consistent accuracy. To a certain extent, this is related to the nature and the availability of the macroeconomic data that are published in quarterly frequency and we are only able to observe the actual numbers long after the period to which they refer to. On top of that, series like GDP, GDI and labour market data are subject to revisions for a long period of time after their first publication and therefore initial estimates often include ‘noise’. Atkeson and Ohanian (2001) in their novel research note that ‘’for the last 15 years, economists have not produced a version of the Phillips curve that makes more accurate inflation forecasts than those from a naive model that presumes inflation over the next four quarters will be equal to inflation over the last four quarters’’. Subsequently, this realisation sets the ground for the development of models that rely on relatively simple univariate and multivariate regression techniques, and they utilise higher frequency indicators of monthly, weekly, or even in daily series. In recent years, some of these concepts have been applied for the development of more advanced models of contemporaneous forecasting or ‘nowcasting’ for the trajectory of the Consumer Price Index in the current month or quarter.
In our analysis, we diligently select a small number of monthly and weekly series able to capture the nature of the shock and create parsimonious models. A key underlying assumption in the selection of the variables is that the origin of the shock does not lie on the demand side and therefore variables such as GDP, capacity utilisation or various other measures of slack in the economy and the labour market offer little or no short-run predictive power. Thus, we select as explanatory variables a commodity index (including energy and food), Producer Price Index for Greece, a domestic house rent price index, the broad Real Effective Exchange Rate (REER), a monetary aggregate measure, and an inflation expectations measure. Subsequently, we estimate a number of different univariate and multivariate models and implement a stepwise weighted average for the most accurate models. Our forecast which is robust to different specifications shows that Inflation in Greece is going to remain below but very close to a double-digit number for the rest of the year and it will decelerate significantly in the first quarter of 2023 and close to 5% in the second quarter of the year. Our estimate predicts an inflation rate close to 5% for April 2023 and it is in line with the OECD’s estimate of headline inflation at 4.2% for the second quarter. Additionally, we estimate a conditional forecast for one optimistic scenario where the commodity index, which induces energy and food amongst others, reverts to the high end of the long-run average (Q2 2021). For November, given the downward trend in the commodity prices our model predicted with remarkable accuracy an inflation rate of 8,6% under the ‘commodity price drop’ scenario against the actual 8,5% inflation rate recently published by the Hellenic Statistical Authority. Even if this trend continues in the coming months, inflation rate in April will run close to 3.5%, 150 basis points away from the target of 2%. In our opinion, this corroborates our analysis in the previous section that price increases are broad-based in the economy and therefore it may take more time than previously thought to revert to the 2% target.
The European Central Bank on the 15th of December acknowledged that the fight against inflation is far from over for the Eurozone and delivered another 50 basis points of interest rate rise. As Christine Lagarde noted the Central Bank had “more ground to cover, we have longer to go”. However, monetary policy operates with lags for the interest-rate-sensitive parts of the economy such as investment and housing and this creates important short-run policy implications. As Greece gradually enters a pre-election period there is a real threat that imprudent fiscal policy can significantly derail the path to 2% of inflation. Increased spending that is not targeted to the most vulnerable to the increased cost of living could inversely affect the persistent service components of inflation that as of now show little signs of moderation. Even though, an inflation-wage spiral is more unlikely for a country with very soft labour conditions like Greece, other countries like the United Kingdom already experience intense demand on behalf of labour unions for wage increases in line with the inflation rate. For Greece, there is a real danger for an excessively generous government to cause de-anchoring of inflation expectations on behalf of the citizens. In this case, the policy has to become even more restrictive to tame inflation with severe repercussions for the growth prospects.
The European Commission estimates that inflation (Y/Y %) is going to be at 6% for 2023 before it decelerates considerably to 2,4% in 2024. What is notable in this case is that according to this estimate Greece will be able to return to the 2,4% target while avoiding contraction.
In a nutshell, according to our forecast, we believe that the peak of the inflation rate is already behind us but the road to 2% will be ‘bumpy’ and uncertain. Geopolitical uncertainty and medium-term weather patterns are only a couple of the known unknowns that make longer-term horizon forecasts particularly challenging.
Note 2: The views and opinions expressed in this analysis are those of the author and do not necessarily reflect the views or positions of any entities he represents.