Inflation shock lessons: joint EU response and green transformation would increase economic resilience
Monetary and fiscal policy measures implemented by central banks and governments have protected the economies of both Lithuania and the euro area from prolonged recession and financial tensions after the shocks of recent years. Today, the Bank of Lithuania’s economics conference speaks about the response of policy makers, lessons learned and measures to increase economic resilience.
“The joint shield of central banks and governments worked and protected the economy from a serious crisis that could have been caused by successive unprecedented shocks as a result of the pandemic and the aftermath of the war. Jobs have been preserved and significant progress has been made in combating inflation, but now it is important to cooperate on completing the work and bringing inflation back to the 2% target in the euro area over the medium term,” says Gediminas Šimkus, Chairman of the Board of the Bank of Lithuania.
“Inflation in September declined to 4.3% in the euro area. This means that about three quarters of the peak gap to our inflation target has faded away. Within this overall trend, the nature of inflation is changing. The complete dynamic adjustment to the past shocks involves a staggered reset of prices and wages across the economy, which is on-going. As wage adjustment is episodic in nature and institutional arrangements vary across the member countries, this is necessarily a multi-year process,” said Philip R. Lane, Chief Economist of the ECB.
While the economy has succeeded in avoiding a deep recession, another acute problem has emerged – a sharp rise in inflation, which has lasted for too long. The good news is that since last year’s peak, the annual inflation rate in Lithuania has already decreased by a factor of five and, according to preliminary data, reached around 4% in September. The decline in inflation was driven by two main reasons:
(1) supply chains recovered following the pandemic and the prices of energy resources declined. This significantly reduces supply pressures on inflation. As tensions in supply chains ease and energy prices drop from record highs, businesses can faster purchase and deliver raw materials and goods needed for production and trade, produce their products at lower costs and compete in terms of price;
(2) unprecedented monetary policy response of the European Central Bank. Since July last year, key interest rates have been increased 10 times, by a total of 450 basis points in order to bring inflation back to its target level over the medium term. Monetary policy helps to ensure that longer-term inflation expectations of market participants continue to remain in line with the target level. The expectation of bringing inflation back to the 2% target reduces pressure on demand and prices. Monetary policy measures are also important because they allow the supply of goods and services to catch up with demand faster by dampening aggregate demand.
One of the most important lessons learned from this price shock is the revelation about the Achilles heel of the Lithuanian economy: under-diversified energy and high dependence on fossil fuels. Last year, energy prices fuelled inflation the most in Lithuania. Not only did they directly contribute to a third of total inflation in Lithuania in 2022, but, through indirect channels, they contributed to an even more rapid price increase, which was one of the highest in the euro area.
Therefore, in order to increase Lithuania’s economic resilience, reduce the dependence on foreign energy suppliers and ensure a reliable and secure energy supply, close cooperation between policymakers and business in the green transformation of Lithuania’s economy is necessary. In such an economy, the share of renewable energy produced in Lithuania would be much higher than today. To achieve this goal, Lithuania needs to make targeted and efficient use of the common European aid instrument, the Recovery and Resilience Facility (RRF). At the same time, it can provide a strong incentive for the country’s economy to return to sustainable growth. According to the European Commission, by the first half of this year, approximately €830 million, or nearly 38% of the total allocated RRF support, had been transferred to Lithuania. This year, the volume of EU investment funds is expected to reach 1.7%, and next year – almost 2% of GDP.