The euro zone and the euro could prove the most vulnerable to persistent inflation in developed nations although much depends on how the ECB reacts.

However, borrowers can gain from rising inflation if it is unanticipated, and some countries will lose out more to high inflation than others and that can have an adverse impact on their currencies.

The euro zone and the euro could prove the most vulnerable to persistent inflation in developed nations although much depends on how the ECB reacts. The vulnerability of the euro zone to inflation is for the same reason that the region can be the fall-guy when other macroeconomic disturbances happen. The reason is that adverse shocks can cause significant differences to arise between countries.

Of course, regional discrepancies can happen within a country – like the US – but these are often smaller and certainly less notable than those that can arise among euro zone countries. When it comes to inflation it is worth noting right now that the country with the lowest inflation in the euro zone is looking at a figure of around 6% while the highest is over 21%. Compare this to when EMU started in 1999 when all the original entrants had inflation very close to the ECB’s 2% target.

In other words, with higher inflation comes higher inflation dispersion. This can happen even if the shock causing inflation is common to all countries. And that’s certainly the case at the moment given the surge in energy prices. Different countries import different amounts of energy, have different schemes to ease the burden of the increase, have different weights for energy prices in their CPI and more. As a result, inflation dispersion has gone through the roof. But why should this be a problem? Mr. Steve Barrow, Head of Standard Bank G10 Strategy views it as a problem on a number of levels and particularly if it proves persistent.

The first is that big divergence in inflation performance can cause competitiveness strains within the euro zone. High inflation countries have no currency to devalue and hence the pain that the economy has to bear to get inflation down can be all the greater.

Secondly, central bankers in the high inflation countries cannot tighten their monetary policy independently to deal with the relatively high prices. There is one policy rate for all countries. What’s more, if ECB bond buying has been biased in the past towards countries that now have very high inflation it can actually mean that relative monetary policy is the wrong way around in the region as it is far too loose for those with high inflation and possibly too tight for those with relatively low inflation.

A third and related issue is that inflation reduction becomes more of a fiscal problem as those with the highest inflation have to run the tightest fiscal policies to both lower inflation and reduce the differential with others. This is clearly what is happening. But fiscal policy is not primarily designed as a tool of inflation management and it is not clear to us that it is ideally suited to doing so.

If we can agree that high inflation is most problematic for the euro zone because it comes with the added difficulty of high dispersion, then does this put the euro in jeopardy? If we think back to another major global shock (like the war in Ukraine) – the 2008 global financial crisis – subsequent years saw substantial pressure on euro zone bonds and the euro because the GFC exacerbated debt discrepancies in the euro zone, nearly forcing one country, Greece, to leave.

Could a similar thing happen now? Mr. Steve Barrow said it would be possible but we do have to bear in mind that the ECB could be far more willing to err on the side of too much policy tightening than too little, relative to others such as the Fed, because the ECB faces this additional dispersion risk. In short, the ECB could be the central bank that lifts rates well above market expectations and this, in turn could lift the euro as rate differentials work in the euro’s favour.

“With this in mind, we are probably less fearful of a crisis in the region, and plunge in the euro, than we were in the run up to the 2010/12 euro zone debt crisis although we dare say that, to many, this might be cold comfort”, said Mr. Steve Barrow.