Spain: High inflation will eventually cause a recession

In May, consumer prices again increased at a near-record pace. According to the flash estimate of statistics office INE, harmonized consumer prices (HICP) increased by 8.5% y/y (Figure 1). While that is less than the series’ high of 9.8% in March, it is an acceleration again from the 8.3% in April. The price rises are rapidly eating into households’ purchasing power, as wage growth is far from keeping up, despite some acceleration since the start of the year (Figure 2).

The inflation breakdown has not yet been published, but from INE’s press release about the national CPI series we take it that higher fuel and food prices were, yet again, the main drivers of the headline rate. In addition, core inflation has accelerated to 4.9% in the non-harmonized national series. This confirms our expectation that inflation is becoming ever more broad-based and stokes fears that high inflation is becoming entrenched[1].

[1] The fact that the share of wage agreements including inflation indexation clauses signed thus far for 2022 and 2023 has increased to respectively 30% and 50%, from about 10% in 2015 and 20% in 2019, further strengthens this risk.

Going forward, we project inflation to peak in the current quarter but to remain very high thereafter. On the one hand, the agreed ban on seaborne oil imports from Russia will send prices of crude oil and petroleum products, i.e. fuel, higher. Even though Spain only imports a small share of its domestic oil needs from Russia, it will still be hit via higher prices for crude and refined products in the global market. Moreover, we believe that we haven’t seen the end of the price increases for food and industrial goods just yet. Higher energy costs and supply chain bottlenecks caused by the Ukraine war, China lockdowns and the legacy of the pandemic, will continue to fuel input costs for especially farmers and manufacturers. With a lag, these higher input costs feed into higher producer prices, which over time adds to consumer price inflation. On the other hand, the government has introduced several support measures to put a lid on inflation. The largest impact should come from a still to be implemented cap on the price of gas (see below). Yet as explained below, the measures will only have some effect. Against this backdrop, we project inflation to average 8.3% this year and 3.3% next year, after 3% last year.

High inflation combined with genuine pessimism among consumers will dent consumer spending once the boost of reopening fades. While excess savings built up during the pandemic will absorb part of the price hikes, these savings won’t prevent a contraction in household spending, in our view. Partly because of the magnitude of the shock, but also because food and energy price inflation has a larger impact on low-income households – which have less savings to begin with. Meanwhile, business investment might still stand to benefit from the reopening of the economy and especially a good tourism season. That said, falling demand, higher costs, tightening credit standards and increasing financing costs will hamper business investments going forward. EU recovery fund money could chip in here, but there continues to be delay in and uncertainty around the use of these funds, while current supply bottlenecks and high input prices will also limit their potential. From a supply side perspective, we expect the services sector to continue to enjoy a reopening boost in the near term. Yet, according to surveys, manufacturing production is already grinding to a halt due to equipment shortages, high input costs and slowing orders.

Putting all this together, we project the Spanish economy to grow slowly this quarter, but to contract towards year-end and through early next year (Figure 4). This results in GDP growth of 3.6% this year and -0.2% in 2023. Admittedly, it is difficult to forecast the timing and depth of the recession. For various reasons the downturn could be more or less intense, or strike at a different point in time. Yet that would not change the narrative of our story: a downturn is in the works.

Starting last year, the government has already introduced a broad range of support measures to counter high energy inflation. Measures include a reduction in taxes on electricity and a subsidy on fuel prices – the latter as a gesture to truck drivers who held roads hostage for three weeks in March and April, causing shortages of fresh supplies in supermarkets and restaurants. In total, the measures implemented so far amount to some €20bn (about 1.5% of GDP). The government aims to partly pay for these measure with a levy on windfall gains of energy companies. So far, reducing taxes on electricity seems to have at least partially paid off, but the impact of the fuel prices subsidy is more ambiguous. After an initial drop when the subsidy was introduced on 1 April, prices at petrol stations have since climbed again. One could argue that prices would have increased even more without the subsidy, but also that the subsidy simply maintains demand for something of which there is too little supply, inducing new price hikes.

A measure that would probably effectively limit inflation is the plan to temporarily cap the price on gas that feeds combined cycle and cogeneration plants. This will drive down the average price of electricity in the wholesale market, which in turn lowers the price of regulated energy contracts. The plan has already been approved by both Brussels and Madrid and should be implemented “as soon as possible”. A back on the envelope calculation shows this could reduce Spanish inflation by some 1.4 percentage points. Key questions are, however, when the plan will be implemented and how it will be financed.

All in all then, we expect government support to alleviate some of the inflationary pressure, which should support GDP growth by several decimal points this year and next. But it won’t be able to prevent a decline in households’ purchasing power and a broader downturn. You simply cannot solve a supply shock by ramping up demand. In fact, broad scale support might even accomplish the opposite, as it could support demand while there is too little supply, inducing higher inflation.