Inflation: why the differences are so clear around the world

Although the worst appears to be over, inflation in the eurozone is still more than double that in the US. But not only between Europe, where the inflation rate was 6.4 percent in June, and the USA with 3 percent, there are clear differences in the price development, there are also enormous differences within Europe. While prices in Germany, for example, have recently risen somewhat more sharply by around 6.8 percent, inflation in Spain was 1.6 percent in June and in Luxembourg it was only 1 percent.

The most obvious reason for the US lead over Europe, according to the prevailing view, is that the Fed started its cycle of tightening earlier than the ECB. That may be true, but there are two other aspects to consider in this context. On the one hand, the question arises as to whether the ECB’s monetary policy measures were delayed due to different interpretations of the causes of inflation, or whether there was also a delay in the start of the price increase.

In the US, inflation climbed above the Fed’s price stability target of 2 percent in March 2021. In Europe – the ECB is committed to the same goal – prices started to rise more than 2 percent in July of the same year. If inflation is mismatched, there must be structural causes for the mismatch, even though the causes of inflation are identical and cyclical in nature. This means that even if the root cause is the same, structural differences can lead to different developments, which in turn are dealt with at different speeds.

As the ECB notes, one of the key differences between US and European inflation is that inflation in Europe is mainly supply-side driven, while in the US it is much more demand-side driven. What we must not confuse, however, is cause and effect. How can the world’s largest economy, which is also much more dependent on imports than Europe, be less vulnerable to shocks in the supply chain? The answer is: no. This shows that the said difference can easily be misinterpreted with regard to inflation, since it refers to the different absorption mechanisms, ie to the effects of inflation and not to its causes. In other words, the role of private consumption in the US economy, or the much more dynamic labor market there, mean that inflation unfolds more quickly, is more sensitive to monetary or fiscal policy measures by the central bank and can therefore be contained earlier.

Enormous differences in Europe

Not only in Europe, but even within the euro zone, there are different inflation figures. Accordingly, fluctuations in the national currencies of non-euro countries, which reflect current economic conditions, may increase or decrease inflation. So this may unduly exacerbate an already severe inflationary scenario, as exemplified by the Hungarian forint, which temporarily spiked above 26 percent earlier this year. However, it can also have positive effects, as can be seen in Switzerland. The country reported an inflation rate of 2.5 percent for June.

Focusing on the single currency zone, we get closer to the main causes of inflation – Covid-19 pandemic and the Russian invasion of Ukraine. There is a clear link between the double-digit inflation rates in the Baltic States and their past interdependence with the Russian economy, both in terms of energy and food. While some economists say the impact of energy prices on inflation is negligible, the countries that have done the most to reduce their reliance on Russian energy supplies have fared the most in overall price increases.

The dilemma of “core inflation”

Core inflation has recently become the focus of economists’ interest in assessing the more “stubborn” components of inflation. The approach is to remove energy and food from the basket used to calculate consumer price inflation. In contrast to the so-called “overall inflation”, which includes all goods in the basket, a more reliable picture of price developments is to be determined by excluding volatile food and fuel prices. Their plausibility is occasionally called into question in the public debate when consumer advocates or politicians argue that it does not matter to people which theoretical cluster a certain component of rising prices is due to, since it is ultimately about the nominal price increase and the be all that matters.

While that sounds understandable, it is important for policymakers to find out to what extent prices are actually rising. They also need to understand what the drivers of higher prices really are, how they are related and what monetary policy actions to take. Interestingly, when looking at long-term historical averages, it doesn’t make much of a difference whether you refer to headline inflation or core inflation when looking at long-term historical averages. However, headline inflation fluctuates so much more around a mean that it provides little insight into the periods observed by central banks. How strong these fluctuations can be is shown by the inflation rate extrapolated to three months on the basis of seasonally adjusted data, which the ECB monitors to capture trend reversals in inflation dynamics.

As noted by the central bank in its March meeting minutes, headline inflation by this measure has fallen from around 11 percent in November 2022 to around 3 percent in February 2023 – a development entirely attributable to slowing energy inflation. Within the core inflation rate, the ECB also monitors and compares energy dependent and non-energy dependent sectors to assess the indirect impact of the energy and food components on core inflation.

Wages fuel inflation less than assumed

In theory, there is demand-side pull inflation, which occurs when aggregate demand grows faster than aggregate supply, or cost-side push inflation, which occurs when output prices rise – as a result of rising commodity prices or wages . There is inflation as a result of a tightening of money supply, as well as built-in inflation when prices rise on the sheer expectation that they will rise.

The latter is increasingly becoming the focus of central bank interest. They want to avoid a so-called unanchoring of inflation expectations. According to this view, inflation expectations are anchored as long as people expect long-term inflation to remain relatively unchanged, even if prices temporarily rise above their short-term inflation expectations. In contrast, inflation expectations are mutable when people’s long-term inflation expectations rise significantly because prices only temporarily rise above their short-term expectations.

This not only explains why central banks have not reacted to high inflation for a long time. It has to be seen in the context of the “second-round effects” of headline inflation. As the ECB put it in its March meeting minutes: “The evolution of earnings relative to wages suggests that wages have had only a limited impact on inflation over the last two years and that earnings growth has been much more dynamic was than that of wages”.

This means that if companies had simply passed the higher costs on to customers, it would have been neutral to profit. This phenomenon can be termed “greed inflation” or “winflation” and while difficult to prove, the ECB report suggests that this is indeed happening and that the extent of its continuation could have implications for inflation.

Other factors that could contribute to higher inflation in the future should not be underestimated, such as a wage-price spiral as soon as there are further rounds of wage increases, or the costs of de-globalization as a result of the relocation of jobs and production to domestic markets, to better manage problems in the supply chain. So far, however, these factors could not be assigned to any significant event. However, “labor costs (…) are becoming a dominant driver of inflation,” as the ECB explained in its latest inflation forecast. In addition, prices in the service sector will have a dominant effect.