Updated: Apr 1, 2022
Over the past few months, Europe has seen a rise in prices for day-to-day items. Usually, when there’s talk of inflation being higher than average, we don’t even notice the change in prices before the European Central Bank (ECB) steps in to fight it with monetary policy. However, this time it is different: just the other day I was walking into a bakery in Barcelona and was amazed to see by how much the prices of the pastries had risen. Inflation has real-life implications and long-lasting effects, such as lowering people’s “real wage”: that is, the amount one can buy with the money they make (Lagarde 2021).
So, why has inflation been rising so rapidly, although the ECB’s primary responsibility is to keep inflation constant at 2%? What could this mean for European citizens? And how long should we expect this situation to go on for?
To start, there are three main drivers of inflation: “mechanical inflation”, energy prices, and supply-demand imbalances.
The term “mechanical inflation” explains the results from base effects of how inflation is measured (ECB 2021). Last year, inflation fell drastically averaging 0.3% due to the harsh lockdown and economic standstill (Lagarde 2021). This automatically leads to higher inflation because the ECB measures inflation on a year-on-year basis.
As aforementioned, energy prices are also an important determinant of inflation rates. At the beginning of the pandemic energy prices were low. Due to the sudden lockdowns many businesses stopped their energy consumption, resulting in an excess in energy supply (Lagarde 2021). However, since spring 2021, energy inflation in the Eurozone soared to 28.6% (Lagarde 2021) in January 2022, contributing to the overall 5.1% inflation we saw in January 2022 (Colijn 2022). This rise is linked to the sudden reopening of the economy as well as a recovery in global demand, restrictions in OPEC+ oil supply, slow US shale oil production, and lower exports from Norway and Russia (Lagarde 2021). The mix of high demand and supply shortages caused European energy prices to soar to record highs.
The third and last main reason accounting for inflation are supply-demand imbalances. There are two sides: on the demand side there has been a jump in industrial goods prices, which has resulted from the pandemic-related switch in consumption patterns from services towards goods (e.g., instead of renewing their gym membership, people buy home workout equipment) (Lagarde 2021). When it comes to the supply side, manufacturers are facing an acute shortage of key inputs (e.g., microchips), which are being exacerbated by the “bullwhip effect” – firms encountering higher demand are placing larger and earlier orders than necessary to ensure goods keep flowing out the door (ECB 2021). That ripples down the supply chain and causes further disruptions and shortages. The service industry is also seeing an uptick in inflation (Lagarde 2021). With countries easing restrictions, people are eating out and traveling again. Meanwhile, labour supply has not yet fully recovered and input costs are rising (ECB 2022). Worryingly, we are seeing high job vacancy rates in some contact-intensive sectors, and the number of employed people has dropped by around half a million, compared to pre-pandemic times (ECB 2021).
So, the important question: how does the future look for us and the Spanish pastries? For the moment, there is no indication that the inflation levels we see now will persist indefinitely. On the level of economic sectors, while supply-demand frictions still exist, we do not observe a skills mismatch in the labor market which would permanently shift output (Lagarde 2021). However the above-mentioned trends are still going to be continuing for a while, likely until mid-2022 (ECB 2022). That means for a little while longer our Spanish pastries will remain at a higher price than we are used to. Nonetheless, this is not going to be the case forever. Europe is expected to converge back to normal inflation levels towards the end of 2022 (ECB 2022), and we can go back to buying our Ensaïmadas at their usual price.
Written by Thais Ayuso Deshmukh , Amsterdam Chapter of European Horizons
Source: The New York Times
Colijn, Bert. 2022. “Eurozone Inflation Hits Record 5.1%, Driven by Higher Energy Prices.”
think.ing.com. ING NL, February 2, 2022. https://think.ing.com/snaps/eurozone-inflation-increases-to-5.1-on-energy-but-core-is-c oming-down/.
European Central Bank. 2021. “An Overview of the ECB's Monetary Policy Strategy.”
European Central Bank, July 8, 2021.
Lagarde, Christine. 2021. “Commitment and Persistence: Monetary Policy in the Economic
Recovery.” European Central Bank, November 19, 2021. https://www.ecb.europa.eu/ press/key/date/2021/html/ecb.sp211119~3749d3556c.en.ht ml.