In 2022, the annual inflation rate hit a record level (8.4%) since the Eurozone’s creation in 1999, mostly because of disruptions in the global supply chain and by the energy crisis provoked by the conflict in Ukraine.
Now the question that must be asked is whether inflation rates will rise or fall in 2023 and beyond. Indeed, a few factors seem to suggest that the European Central Bank’s (ECB) inflation target of 2% could be reached if other circumstances don’t intervene to maintain it at high levels.
Is the worst behind us?
A decrease in the prices of raw materials could suggest that inflation will slow down. After inflation peaked at 10.6% (year-over-year) in October 2022, the most recent data in January showed a decrease to 8.5%. The fall in raw material prices after historic highs is an important reason why prices are rising more slowly. Indeed, food, living and energy costs make up 35% of the global Harmonised Index of Consumer Prices (HICP).
Supposing that tensions don’t return to these highly volatile markets, the baseline effect (that’s to say, with the transitory effects removed) in the months to come will be ever more favourable, thus lowering global inflation.
Another factor might lead to a slowdown in the inflation rate: inflation expectations. In spite of what the public might think, these expectations are indeed one of the main engines behind rising prices today. With this in mind, central banks carefully monitor consumer and professional forecasters surveys to evaluate sentiments about inflation.
According to the ECB’s last report, consumer forecasts stand at 5.0% for this year while long-term inflation expectations are unchanged at 2.9%. At the same time, experts have revised their forecasts for HICP inflation for 2023 and 2024; and have increased them compared to the previous survey (the fourth quarter of 2022), to 5.9% and 2.7% respectively. In combination, these two indicators are a positive sign that inflation expectations in the medium term are well within ECB objectives, and that the scenario of inflation getting out control is unlikely (for the moment).
Lastly, one mustn’t forget that monetary policies take some time to affect the economy, with effects kicking in 12 months after at the earliest and at their strongest 24 month after).
Thus, we will only feel the impact of the ECB’s first interest rate rise (in July 2022) by mid-2023. If the economy of the Eurozone has shown some signs of slowing down in the last quarter of 2022, the “delaying” effect of a rise in interest rates will certainly have an impact on growth in 2023, which is expected to settle at 0.7% after reaching 3.5% last year.
Meanwhile, a number of arguments could lead us to believe that prices will stay high. First, inflation rates remain at more than 7% in the larger countries of the euro zone. Germany, France and Italy have not yet experienced a significant slowdown. In short, prices of European goods continue to rise.
A spike in springtime ?
Research on the persistent nature of inflation conducted by the ECB showed that prices are infrequently updated and on an irregular basis. This could lead to “secondary effects” and it could take a while for the inflationary impact of raw material prices to affect the wider economy. It’s not a surprise to learn that supply costs have not yet been entirely transferred to retailers or large supermarket chains. According to Michel-Édouard Leclerc, the head of the E. Leclerc brand, prices could spike “between April and June”.
It’s also interesting to note that price rarely change for non-energy industrial goods and for services in particular. During her last press conference on February 2, the ECB president, Christine Lagarde, took care to emphasise that underlying inflation (other than food and energy) had hit 5.4% in December, a Eurozone record. Prices remain stubbornly high in the Eurozone (more than in the USA), which explains the hawkish attitude of certain ECB officials for whom the fight against inflation isn’t yet won.
Up until now, the wage-price spiral remains under control in spite of recurring problems of labour shortage in a few countries. However, the ECB expects that with a labour market that is still resilient at the beginning of this year, wages could increase even more.
In the 1970s, the wage-price spiral following the oil crises was responsible for sticky inflation rates. In a 2004 research paper, I argue the extent of inflation persistence diminished when monetary authorities adopted inflation targeting policies, and that wage indexation had become the exception rather than the rule. Meanwhile, as Christine Lagarde recognised, wages will constitute an important part of inflationary pressure in the months to come.
There is a consensus that the ECB (as well as the US Federal Reserve, the Fed) was late in raising its key interest rate last year.
Will we see more policy blunders from central bankers this year? In the Financial Times, the journalist Martin Wolf writes that as inflation had started to go down at the beginning of the 1970s, the Fed reduced its key rate too early. It is also interesting to note that short-term interest rates (financial products that ensure the purchase or sale of assets at a determined price and date) imply that the Fed, like the ECB, could lower their key rates as early as this year.
To sum up, it is difficult today to say which factors will be the most important, particularly given the climate of uncertainty that monetary and budgetary authorities have no control over. Even if the general consensus is that there will be steady disinflation in the Eurozone, the global economy remains vulnerable to other unpredictable geopolitical shocks that could lead us back on a re-inflationary path similar to the 1970s. If history never repeats itself, it does often rhyme. That’s why humility and determination should be the guiding principles of those at the helm of monetary policy.
Translated from French by Fleur Macdonald.