When, after decades of stable prices, inflation reached double digits in many corners of the world, central banks reacted in the US and in Europe alike, with interest rate hikes being decided on by the Federal Reserve and the ECB.
But the origin of the inflation in the US and in Europe was not the same (see for instance Visco 2023). In the US, inflation took off at the beginning of 2021, as the easing of Covid-19 restrictions and strong demand – the result of pent-up demand and powerful fiscal stimuli for households – put pressure on prices across the entire economy. In the EU, core inflation remained low, almost flat, for most of 2021, despite growing energy prices. The increase in prices was confined to the energy market, with other goods and services largely unaffected. In July 2021, core inflation reached 4.5% in the US, while in the EU it stood at 1.2%; in January 2022, it plateaued at 3% in Europe, about half of the level in the US (see Figure 1). The Russian invasion of Ukraine changed the outlook for European markets. Gas prices skyrocketed, infecting the rest of the economy, with core inflation reaching an all-time high of 8.6% at the beginning of 2023.
Figure 1 Inflation in the US in Europe
Note: Core inflation excludes energy and food.
Source: Eurostat and US Bureau of Labor Statistics.
Understanding the dynamics behind inflation matters greatly if you want to stop it. In the European case, the culprit was clear: gas prices, specifically driven by Russian gas prices.
For this reason, the Italian strategy for fighting off inflation was deeply intertwined with its energy diversification policy. The plan Italy put forward during Mario Draghi’s government rested on three pillars.
- The first pillar was the rapid reduction of dependency from Russian gas, the main driver of price increases in Europe.
This translated into the diversification of gas suppliers, which led to a reduction of gas imports from Russia from 40% to 15% of total gas imports in a matter of months. Gas use was also reduced by increasing the share of renewables in the national energy mix and by restricting gas demand. Without pursuing this strategy, Italy would have remained overly exposed not only to energy security risks, but also to the level and volatility of Russian gas prices.
- The second pillar was the push for a European price cap on gas.
The aim of the cap was to address the price increase at the source, and thus prevent it from spreading to other sectors of the economy. Although the strategy seemed straightforward, implementing it proved harder, as several EU countries were sceptical of how it would impact gas supply. Although discussions had already started in late 2021, an agreement was only reached on 19 December 2023. The closer negotiations got to succeeding, the faster prices dropped, with prices falling from €135 to €85 per MWh in the space of two weeks (Figure 2). Although mild temperatures also played a role, the price of TTF gas futures shows an abrupt fall precisely around the approval of the price cap (the EU Market Correction Mechanism). Taking so long to find an agreement was not costless: inflation had enough time to find its way into the entire economy, affecting other sectors. This explains why headline inflation dropped in March 2023 thanks to the lasting decrease in gas prices, but it was paired with a continuing rise in core inflation (see Figures 1 and 2).
Figure 2 Dutch TTF gas prices (futures May 2023)
Source: ICE Index
- The third pillar was the use of fiscal policy to shelter the economy from the energy price shock.
To mitigate the impact of price increases, the government used both tariff mitigation and compensating transfers to firms and households, focusing on the most vulnerable parts of the economy. It targeted energy-intensive firms to cushion the passing of price increases onto customers, thus delaying contagion to other sectors of the economy, and it focused on lower-income households, which are more exposed to energy price inflation. Thus, fiscal policy was used ex ante to avoid an income shock, limiting the need to intervene ex post. In other words, the government used debt to contain inflation and fight off a recession, aiming to keep incomes stable and debt sustainable by anticipating action. As shown in Figure 3, in 2022 the Italian government spent €57 billion, about 3% of GDP, of which €16 billion benefitted households at risk of poverty and €23 billion helped energy-intensive firms, with the rest serving both.
Figure 3 Italian government spending on energy and inflation mitigation in 2022 (€ billion)
Source: Italian Parliamentary Budget Office (UPB 2022)
Did this strategy work? Debt, growth and inflation
The strategy was effective in terms of growth: the Italian economy proved resilient, consistently doing better than predictions and avoiding a recession (see Table 1).
Table 1 Real GDP growth in Italy: IMF predictions and outcomes
Source: IMF World Economic Outlook and Istat.
The strategy was also successful in terms of debt sustainability.
By avoiding a fall in consumption, transfers prevented a fall in GDP. With some help from inflation starting towards the end of 2021, the debt-to-GDP ratio decreased by over 10 percentage points between 2020 and 2022 (see Figure 4).
Figure 4 Debt-to-GDP (left axis) and deficit-to-GDP (right axis) in Italy
Looking at inflation, core inflation remained low for several months despite increasing energy (electricity, heating and transport fuels) prices, similarly to what was happening in the rest of Europe (see Figure 1). However, in the course of 2022, skyrocketing gas prices ended up contaminating the rest of the economy. The success of the Italian strategy on this front was impaired by the delay in the agreement on a European price cap, which came too late to halt the exceptional price peaks of the summer and to stop inflation from propagating.
The strategy had significant positive effects on income distribution (Curci et al. 2022). According to a study by the Italian Parliamentary Budget Office (UPB) using Italian Statistical Office (Istat) survey data, government policies reduced the impact of inflation on household budgets by about one half: the average expenditure of Italian households increased by 3.7% between June 2021 and September 2022. Absent government intervention, inflation would have pushed expenditures up by +6.9%.
For households in the lowest-income decile, the effect was even more pronounced: government policies reduced the impact of inflation on budgets by 88% (estimated increase absent government intervention +9.6%; actual increase +1.3%). Government policies also reduced inequality (the Gini index fell from 30.4% to 29.6%) and the risk of poverty (from 18.6% to 16.8%) as shown by Istat (2022).
Figure 5 Change in household expenditure between June 2021 and Sept 2022: Impact of inflation and government policies
Source: Italian Parliamentary Budget Office (UPB 2022)
The recent debate over inflation, both in Europe and the US, has mostly focused on the effectiveness of central banks in curbing it and on the unintended consequences of the sudden rise in interest rates on financial fragility.
The Italian experience during the Draghi period shows that governments can play a direct role in tackling inflation. They can do this by acting on the source of price increases to fend them off, and by sheltering the economy from price increases once they happen, thus slowing down their diffusion throughout the economy. For the Draghi government, this translated into three pillars: intervening on energy price dynamics with a bold diversification policy and with a push for a Europe-wide gas price cap, and using targeted subsidies.
The strategy put in place managed to avoid a fall in consumption and output, thus averting a decrease in GDP. As a result, even in the presence of significant budget deficits – the result of transfers and subsidies – Italy’s debt-to-GDP ratio actually fell. Using targeted measures also had positive effects on income distribution.
This suggests that fiscal policy and other government instruments in some settings – such as the one we discuss in this column – can be used to dampen the effects of an inflation shock, complementing the role of central banks in achieving price stability.
Authors’ note: The authors were members of Prime Minister Draghi's cabinet (2021-2022). We thank Ferdinando Giugliano for very helpful comments.
Curci, N, M Savegnago, G Zevi and R Zizza (2023), “The redistributive effects of inflation: A microsimulation analysis for Italy”, VoxEU.org, 14 January.
Fabra, N, K Neuhoff and N Berghmans (2022), “European economists for an EU-level gas price cap and gas saving targets”, VoxEU.org, 16 November.
Istat (2022), “La redistribuzione del reddito in Italia”, 23 November.
UPB – Ufficio Parlamentare di Bilancio (2022), “Gli effetti distributivi dell’aumento dei prezzi e delle misure di sostegno in favore delle famiglie”, Flash Report No. 2, 18 October.
Visco, I (2023) "Monetary policy and the return of inflation: Questions, charts and tentative answers", CEPR Policy Insight No. 122, April