MNI INTERVIEW: Germany Facing Deeper Recession - Bofinger

Germany faces an economic contraction of greater than 0.3% next year as inflation rises further, eating into consumption, a former member of the German Council of Economic Experts told MNI.

Speaking after the ifo Institute predicted that an increase in average harmonised inflation from 8.1% in 2022 to 9.3% in 2023 will see the economy tip into recession, Peter Bofinger said that the researchers had over-optimistically assumed that a reduction in real wages will be compensated by lower savings rates, supporting spending.

“There are many households who are not able to respond to this - the lower 50% of German households don't have the possibility to compensate, and therefore to avoid a stronger reduction in consumption,” Bofinger said in an interview. “Given this forecast for inflation, my view is that a deeper recession seems likely.”

Wage increases, while failing to keep pace with inflation, will keep price pressures elevated, said Bofinger, now professor for monetary and international economics at Wurzburg University.

“The ifo forecast has unit labor costs rising by 6.2 %, which reflects a productivity decline by 0.5% and nominal wage increases of 6.7%,” Bofinger said. “This implies that wages contribute to inflation pressure, as wage increases compatible with the ECB inflation target would have to be close to 2 %.”

GAS PRICE

Gas prices are also set to remain high despite Germany’s gas storage having reached 88.33% of capacity even as Russia shuts off supplies.

“For winter there's a risk that the quantity [of gas in storage] is insufficient if we have a really cold winter. But even if there is no quantitative problem, there is still a price problem, because we get supplies that are relatively expensive," he said.

A EUR65 billion cost of living aid package announced by the German government is insufficient, he said, noting that much of the assistance consists in limiting tax increases to households whose incomes have not risen in line with inflation.

“For the middle class and especially those above the very low incomes, more fiscal support is required,” Bofinger said. “This also applies to small- and medium enterprises. Company loss carrybacks should be extended from two years to three years, so that losses this year can be compensated with profits before COVID.”

While Germany’s ‘Traffic Light’ coalition government may yet make good on its pledge to return public spending to levels commensurate with the constitutional debt brake next year, he said, this would come at the cost of promised infrastructure projects.

“If things develop even worse than the ifo forecast, I doubt they can get back to the debt brake in 2023,” Bofinger said. “There are a lot of buffers in the system, such as some debt ceilings that were not used in the past that can be transferred to next year. But if this leeway is used to compensate companies and private households, it would have a negative impact on public investment.”

RATES HIGHER THAN CORE INFLATION

Meanwhile, the European Central Bank may have to hike rates above levels of core inflation, he said, pointing to lessons learnt the 60s, 70s and 80s.

“In the end, the nominal rate had to exceed the inflation rate, or at least core inflation,” Bofinger said, though he added that policy makers should continue to calibrate their response.

“I have the sense that the ECB now feels that they went too late and with too little, so there's a risk that they want to do it faster and more determined,” he said. “[ECB Executive Board Member] Isabel Schnabel said in Jackson Hole that the ECB wants to shift from a “path of caution” to a “path of determination”. I hope that the ECB will remain cautious even on the path of determination.”

Nonetheless, the Taylor rule would imply that the nominal interest rate should be increased by more than the percentage-point increase in inflation, he said, noting that a Bundesbank survey shows that inflation expectations of private households have gone up at least by two percentage points.

“If the ECB increases the nominal rate by approximately two percentage points, the real rate remains constant,” Bofinger said. “Focusing on real interest rates, the ECB could avoid the criticism that they are killing the economy by being restrictive at a time when the recession is already there. A change in the ECB’s communication to real rates would avoid a lot of unwarranted criticism."