Inflation: The high price of Europe’s dependence on fossil fuels

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

The inflation in Europe is driven by energy prices, which the ECB cannot really influence. epa09863193 [David Arquimbau Sintes (EPA-EFE)]

The current rise in inflation is being driven by a rise in fossil fuel prices, and a tightening of the monetary policy by the European Central Bank (ECB) would not help against high prices and might even come at a great cost to the economy, argue the Green MEPs from the ECON Committee Ernest Urtasun, Piernicola Pedicini, Bas Eickhout, Damien Carême, Rasmus Andresen, Henrike Hahn, Claude Gruffat, Kira Marie Peter-Hansen, Karima Delli, Philippe Lamberts.

More than a month after the outbreak of the war in Ukraine, the latest data show that euro area inflation was up to 7.5% in March, with the figure hitting 9.8% in Spain. All this time inflation has been overwhelmingly driven by soaring energy prices, which explained more than 50% of the increase in consumer prices.

This figure only reflects the direct impact, but energy costs have been also pushing up prices across many sectors, which makes the overall effect higher. And that is not all: the rise in energy prices is dominantly linked to fossil fuels, namely oil and gas. The ECB called it “fossilflation”.

Two observations can be drawn from this fact. First, it is no coincidence that energy prices increased even more after Russia’s attack. Europe relies heavily on Russian gas and Putin is setting higher prices on its fossil fuels exports to finance its deadly war.

This means that when importing fossil fuels from Russia, Europe is not only financing Putin’s war but it is also importing high prices to the bloc.

Second, the assumption that no matter where inflation comes from, it should automatically lead to a tightening of monetary policy does not consider the underlying drivers of inflation.

A more restrictive monetary policy would be the right choice if higher prices were driven by higher demand, as it is currently the case in the United States. But this is not the case in the euro area, where inflation is mainly due to higher costs of energy supply.

Not only won’t higher interest rates counter higher energy prices, but if monetary policy stops being accommodative too early this would be extremely costly for our economy.

Speed up the energy transition

Rather than raising interest rates, the appropriate response to surging oil and gas prices translating into higher bills for European citizens is stopping Europe’s high dependence on import of fossil fuels that have been driving up overall prices.

Speeding up the energy transition by investing in energy efficiency measures and in renewables is the most effective policy solution to the current spike in inflation. This is especially important as inflation hits lower incomes harder than higher incomes. And it is why, on top of a swift green transition, redistributive policies and taxation are very much needed in the current context.

While there are strong arguments against raising interest rates in the current context, this does not mean that the ECB should not contribute to the overall objective of a cleaner energy mix. Not only does the current energy mix affect the ECB’s ability to keep prices stable because of the current fossil-driven inflation, but also because physical risks will lead to more persistent and dramatic price pressures, if we do not stop climate change.

It follows that the ECB should act swiftly, starting by greening its targeted long-refinancing operations, and stop buying assets that contribute to climate change and environmental degradation.

The ECB can handle “greenflation” better than “fossilflation”

Some fear that the green transition is putting further pressure on overall prices: the so-called “greenflation”. But greenflation has had so far much less of an impact on final consumer prices than “fossilflation”. This means it is inaccurate to claim that the greening of our economies is to blame for the painful rise in energy prices.

On the other hand, if we are serious about meeting the 2030 and 2050 climate targets, a massive mobilization of green investments will be needed. And like any extensive fiscal stimulus, this is likely to boost inflation.

But there is a substantial difference between an increase in prices driven by more expensive imports from Russia and the implications of Europe mobilizing resources for its energy sovereignty.

The former is a pure cost and it comes with a very high geopolitical cost to bear, namely the economic dependence on its energy provider. But if Europe puts money into a well-functioning green energy infrastructure that remains in its hand, that’s an investment and not a cost.

From the point of view of the ECB, inflation driven by an increase in public and private spending on renewables is manageable with standard monetary policy tools. This would be inflation driven by higher demand, which the ECB has the proper arsenal to tackle.

The same cannot be said of high prices due to external supply shocks, and that’s why monetary policy seems rather powerless at the moment.

One should also consider the size of the impact. From a price stability perspective, longer-term inflation stemming from extreme weather events, resource shortage, and high energy import prices imposed from oppressive regimes abroad is a much more dramatic outlook than temporary higher prices during the green transition period.

The ultimate solution is not in raising interest rates and diversifying Europe’s import of gas. Accelerating the energy transition is.

What should the European Central Bank do about inflation?

As fears over inflation intensity, analysts caution that while energy costs and supply chain issues exacerbate the problem, the European Central Bank cannot do much to stop it.

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