Welfare costs of anti-inflation policies in Portugal

Consumer price inflation in Portugal reached 8.0% in May 2022, the highest level in 28 years. People worry about high inflation because they fear their purchasing power will be reduced, but that is not an inevitable result of inflation. For example, in the 5-year period ending in 1991, inflation in Portugal averaged 12% per year, but in that period real wages and the real National Disposable Income increased annually by 7% and 6%, respectively.

The welfare costs of inflation depend on the nature of the inflationary process, and on the policies adopted to fight the effects of inflation. The information we have today about the nature of the current inflationary event leads to the conclusion that the policy responses announced by the Portuguese Government either were irrelevant or did contribute to reduce the real National Disposable Income of Portugal, thus reducing welfare.

The current inflationary event is the result of global supply and demand factors that are likely to be temporary. Supply was disrupted by COVID19 lockdowns and by the Russian invasion of Ukraine, that we hope will eventually disappear. Fiscal, monetary and savings impulses combined to generate the largest aggregate demand stimulus in human history in 2021/22, a stimulus that is likely to be reverted by 2023/24. The fiscal impulse of 2020 (more than 4% of world GDP) has been partially reverted since 2021. The excessively expansionary monetary policy of 2021 has started to be corrected in the USA and will soon be reversed in the Euro Zone. The end of COVID19-related restrictions allowed households to use accumulated savings to consume higher than usual levels of the services severely affected by the lockdowns, especially tourism related services, but this compensation effect is likely to disappear by 2023/24.

Note that the temporary nature of current inflation does not imply that price increases will be reverted. Oil prices increased from around $60 to around $120 in one year. If prices stay at this high level for another year, then oil price inflation will fall from 100% in 2022 to 0% in 2023. In this case, oil inflation will be temporary, but the price increases will be permanent.

Given that global inflation has been concentrated on raw materials, at it is usually the case in demand-driven global inflation, it is not surprising that inflationary pressures in Portugal are concentrated in food, energy, and tourism (the main beneficiary of the savings impulse). Only 4 of the 12 groups of products in the consumer price index had 3-year price increases (between April 2019 and in April 2022) above the expected 2% annual inflation: food, home (highly dependent on electricity and gas prices), transport (dependent on oil prices) and restaurant and hotels (tourism).

So, current inflation is not a pure inflationary event, with all prices increasing at the same rate, but it is also an event that is changing relative prices. Food and energy become more expensive relative to other goods and services, causing a global redistribution of income from food and energy importers, like Portugal, to food and energy producers. Portugal will lose real disposable income, and the only policies that can minimize this loss are policies that reduce imports of food and energy. Even if the price elasticities of energy and food are low, they are not zero, implying that price increases reduce consumption and thus imports (even if not by much). Any price reducing policy at the national level contributes to higher imports of food and energy, and thus reduces the real National Disposable Income of Portugal.

The Portuguese government responded to the surge in inflation announcing a package of 18 policies that focus on reducing costs to energy and food users, through tax reductions, subsidies, and price controls. Lowering taxes on gasoline or diesel, or capping gas prices, will burden the Portuguese taxpayers while artificially lowering domestic prices of energy, which will lead to higher imports, and thus to national income losses, reducing total welfare, although with some benefits to a few firms.

The public sector is the main beneficiary of higher inflation because public sector revenues will increase in line with inflation, but public expenditures will not. Social transfers (e.g. pensions) and civil servants’ wages (together representing 65% of total expenditure) will increase at the rate set by the government, which is well below expected inflation. Only interest expenses will be higher, due to higher interest rates, but interest expenses represent only 5% of total expenditure. Also, inflation will make public sector debt lower in real terms, and as percentage of GDP. Inflation will increase the real income and the real value of net assets of the public sector.

Welfare improving policies would be those that redistribute income from agents that benefit from real income increases (the public sector) to agents that suffer real income losses (households and firms), instead of subsidizing consumption of imported goods. Policies like transfers to energy-intensive firms based on their 2019 energy consumption and not on 2022 consumption, to create incentives for those firms to reduce energy consumption as much as possible. Or increases in social transfers to low-income households, that should be permanent given that price increases are likely to be permanent (even if inflation is transitory); one-off transfers, like the €60 food transfer or the €10 gas transfer to some low-income families announced by the government, are almost irrelevant in helping to deal with permanently high prices. And finally, increasing social transfers and civil servants’ wages in line with expected inflation would provide income support to millions of households, which is after all, what the Government should be focusing on, instead of spending millions on inefficient consumption support.