Inflation Developments in the Euro Area Since the Onset of the Pandemic

Nickel, Christiane; Koester, Gerrit; Lis, Eliza Article Inflation Developments in the Euro Area Since the Onset of the Pandemic Intereconomics Suggested Citation: Nickel, Christiane; Koester, Gerrit; Lis, Eliza (2022) : Inflation Developments in the Euro Area Since the Onset of the Pandemic, Intereconomics, ISSN 1613-964X, Springer, Heidelberg, Vol. 57, Iss. 2, pp. 69-75, https://doi.org/10.1007/s10272-022-1032-y This Version is available at: https://hdl.handle.net/10419/262941 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ ZBW – Leibniz Information Centre for Economics 69 Forum the euro area) to 0.3% in December 2020 (see Figure 1). The initial decline in headline infl ation was mainly due to a fall in the contribution of energy infl ation resulting from collapsing oil prices. Headline infl ation fell further in the second half of the year as HICP infl ation excluding energy and food (HICPX) also increasingly contributed to the disinfl ationary tendencies, mainly owing to a decline in services infl ation and, to a lesser extent, a decline in non-energy industrial goods (NEIG) infl ation. This can be linked to pandemic-related restrictions but also to temporary factors like the reduction of the German VAT by three percentage points in the second half of 2020 (O’Brien et al., 2021). From January 2021 on, headline infl ation showed a strong upward trend bringing headline infl ation to 5.9% in February 2022. While energy infl ation played a key role in this upward trend of headline infl ation since autumn 2021, higher NEIG and services infl ation as well as higher food infl ation in recent months have also been important. Energy infl ation is currently accounting for more than half of headline infl ation Oil and gas prices fell sharply at the onset of the pandemic.1 This large drop refl ected mainly the negative impact of the pandemic on energy demand (Koester and Rubene, 2021). As a result, the annual rate of change of HICP energy declined markedly, reaching its trough in May 2020 at -11.9%, levels last observed in 2009, and HICP energy infl ation contributed negatively to headline infl ation through most of 2020 (see Figure 1). Since mid-2020, energy prices started to rise as global demand recovered and supply constraints, especially on the gas market, rose. Consequently, HICP energy increased from its trough in May 2020 to 28.8% in January 2022 – with base eff ects linked to the previous collapse of oil prices contributing around ten percentage points to HICP energy infl ation. Data for the fi rst months of 2022 suggest that the contribution of gas and electricity prices to HICP energy infl ation has increased further (see Figure 2), with prices for electricity and gas being reset at the start of the new year in many countries. Overall energy infl ation accounted for more 1 The immediate decline in the oil price was particularly pronounced as for instance the Brent crude oil price dropped by 75% while the Dutch Title Transfer Facility (the Dutch trading hub for gas and the main reference hub for gas trading in Europe) gas price fell by 44% between February and April 2020. The coronavirus (COVID-19) pandemic shock required lockdowns and containment measures in the euro area, which implied a shutdown of businesses and/or an increase in costs for some sectors. The shock was multidimensional, stemming from both external and domestic sources, hitting both demand and supply and aff ecting both the aggregate and the sector-specifi c level. At the same time, the pandemic shock was countered by an unprecedented policy response both at the national and the supranational level. In combination, all of this has led to considerable volatility of infl ation in the euro area. As measured by the Harmonised Index of Consumer Prices (HICP), headline infl ation in the euro area, which had equalled 1.2% in 2019, fell to 0.3% in 2020 and was even negative in the second half of 2020 before increasing again to 2.6% in 2021. Since mid-2021, headline infl ation increased particularly sharply and reached a historical high of 5.9% in February 2022. This article discusses the drivers of infl ation developments in the euro area since the onset of the pandemic as well as the recent infl ation outlook, which has become very uncertain and will crucially depend on how the war in Ukraine will unfold. The pandemic has shaped the pattern of infl ation in the euro area Headline infl ation as refl ected in the HICP – the index underlying the ECB’s defi nition of price stability (Eurosystem work stream on infl ation measurement, 2021) – showed a decreasing trend over 2020 and declined from 1.2% in February 2020 (before the start of the pandemic in DOI: 10.1007/s10272-022-1032-y Intereconomics, 2022, 57(2), 69-75 JEL: E31, P44, J30 Christiane Nickel, Gerrit Koester and Eliza Lis Infl ation Developments in the Euro Area Since the Onset of the Pandemic © The Author(s) 2022. Open Access: This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/). Open Access funding provided by ZBW – Leibniz Information Centre for Economics. Christiane Nickel, European Central Bank, Frankfurt am Main, Germany. Gerrit Koester, European Central Bank, Frankfurt am Main, Germany. Eliza Lis, European Central Bank, Frankfurt am Main, Germany. Intereconomics 2022 | 2 70 Forum prior to the pandemic where the shocks driving infl ation were more equally distributed and refl ected both external as well as domestic factors. Underlying infl ation increasing and broadening Indicators of underlying infl ation, which signalled low infl ation in the euro area for an extended period from 2013 to 2019 (Koester et al., 2021b) have remained subdued since the start of the pandemic before picking up strongly over recent months. As no single measure of underlying infl ation has proved superior, the ECB is usually monitoring a broad range of diff erent indicators (Nickel and O’Brien, 2018; Ehrmann et al., 2018). HICP excluding food and energy infl ation rose to 2.7% in February, up from 2.3% in January (Figure 4). Measures of underlying infl ation that seek to remove the impact of temporary factors like HICPXX infl ation (which, in addition to energy and food, also excludes travel-related items, clothing and footwear), the model-based Persistent and Common Component of Infl ation (PCCI) and the Supercore indicator (which comprises cyclically sensitive HICP items), have tended to edge upwards in recent months. While all indicators of underlying infl ation have moved above 2%, this probably refl ects – at least in part – the indirect eff ects of elevated energy prices. Price pressures have been broadening across the spectrum of goods in the euro area (see Figure 5). This is refl ected by the fact that the share of items with infl ation than half of headline infl ation in February 2022. The Russian war in Ukraine has implied a further soaring in energy prices and energy infl ation to a new historical high of 32% in February 2022 and increased the uncertainty about the future path of energy prices and infl ation more generally. Indirectly, higher energy commodity prices also feed in through the pricing chain via higher input costs to food, non-energy industrial goods and services (Koester et al., 2021a). NEIG and services with high energy intensity such as pharmaceutical products or travel services can be particularly aff ected. The rising energy costs have likely contributed to increases in food infl ation and non-energy industrial goods infl ation – which stood at 4.1% and 3.0% respectively in February. Yet, this pass-through takes time and unfolds over years, implying that rising energy prices will likely push up food and underlying infl ation in the future. External factors have played a key role for infl ation developments in the euro area Already now, the largest part of infl ation in the euro area refl ects shocks generated abroad, via net imports of energy and commodities or via the import content of other goods and services. This can be illustrated by decomposing HICP infl ation into energy and food as well as into items with a high and a low import content (Figure 3). Infl ation in items with low import content, for which domestic price pressures play a key role, has been much lower than for HICP and also HICPX. This contrasts with the period Figure 1 Headline infl ation and its main components annual percentage changes; percentage point contributions Note: The latest observations are for February 2022. Sources: Eurostat and ECB calculations. Figure 2 Decomposition of HICP energy infl ation annual percentage changes; percentage point contributions Note: The latest observations are for February 2022. Sources: Eurostat and ECB calculations. -1 0 1 2 3 4 5 6 Jan. Mai Sep. Jan. Mai Sep. Jan. Headline HICP inflation Energy Food Non-energy industrial goods Services 2020 2020 2020 2021 2021 2021 2022 -15 -10 -5 0 5 10 15 20 25 30 35 Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sep. Oct. Nov. Dec. Jan. Feb. Other Gas Electricity Fuel Energy Energy long-term average 2020 2021 2022 ZBW – Leibniz Information Centre for Economics 71 Forum lated services, for quite some time with a direct impact on service infl ation (Lis and Nordeman, 2021). At the same time, a relative expenditure switch towards the consumption of goods has strongly increased demand for goods. In addition, manufacturing production continued to be rates above 4% (accounting for 24% of items in December) and of items with infl ation rates between 2% and 4% (accounting for 44%) has strongly increased. A year ago – in February 2021 – these shares were much lower and equalled 6% (share of items with infl ation rates above 4%) and 10% (share of items with infl ation rates between 2% and 4%). Supply bottlenecks and reopening eff ects have played a key role The pattern observed in underlying infl ation in the euro area can be linked to developments in the real economy with a large decline in global economic activity in 2020 followed by a signifi cant recovery starting in the third quarter of 2020 and a boost from the rollout of vaccine programmes since late 2020 (Lane, 2021a). This is in line with the fi nding that while the assessment of the euro area Phillips curve (linking infl ation to developments in economic slack) has become more complicated due to numerous confounding factors during the pandemic, it is still at play – even if it is hard to pin down precisely (Bobeica et al., 2021). The economic recovery has remained asymmetric as social distancing has constrained demand and activity levels in high-contact service sectors, especially travel reFigure 3 Contributions from items with high and low import content to HICP infl ation annual percentage change and percentage point contributions Notes: Items with low import content refer to the items in the HICP that are characterised by a direct and indirect import content in consumption expenditure of less than 15%. Decomposition based on Fröhling et al. (2021). Latest observations: February 2022. Sources: Eurostat, WIOD and ECB staff calculations. Figure 4 Indicators of underlying infl ation annual percentage changes Notes: The range of indicators of underlying infl ation includes HICP excluding energy, HICP excluding energy and unprocessed food, HICPX, the 10% and 30% trimmed means, and the weighted median. The latest observations are for February 2022. Sources: Eurostat and ECB calculations. -1 0 1 2 3 4 5 6 Jan. 2019 Jul. 2019 Jan. 2020 Jul. 2020 Jan. 2021 Jul. 2021 Jan. 2022 Energy and food Items with high import content other than food and energy Items with low import content HICP 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Jan. 2020 Jul. 2020 Jan. 2021 Jul. 2021 HICP excluding energy and food (HICPX) HICP excluding energy, food, travel-related items Persistent and common component of inflation Supercore Trimmed mean (10%) Trimmed mean (30%) Feb. 2022 and clothing (HICPXX) Figure 5 Distribution of infl ation rates across items included in HICPX infl ation % Note: Latest observation February 2022. Sources: Eurostat and ECB calculations. 0 20 40 60 80 100 Jan. 2019 Jul. 2019 Jan. 2020 Jul. 2020 Jan. 2021 Jul. 2021 Jan. 2022 Below 0% Between 0% and 2% Between 2% and 4% Above 4% Intereconomics 2022 | 2 72 Forum low-contact services increased only very moderately (Figure 7). This refl ects a key role of re-opening eff ects linked to the easing of the containment measures as well as an impact of the energy price increase – which pushes up costs for transportation, which are also part of the high-contact services. Wage growth has remained muted and longer-term infl ation expectations have re-anchored Wage growth – a major driver of services infl ation in the euro area – has remained moderate thus far. Important measures of wage growth like compensation per employee or compensation per hour have been heavily affected by the changing impact of government support measures related to job retention schemes (Dias da Silva et al., 2020). Workers maintained their employment status but actual hours worked per person declined and workers only received part of their usual compensation, lowering compensation per employee while annual growth in compensation per hour increased. Over the course of the pandemic, the divergence between compensation per employee growth and compensation per hour growth was strongly aff ected by the importance of job retention schemes. The distortion from these schemes has declined recently and can be expected to remain moderate looking ahead – but will not entirely disappear until the pandemic is fully over and these support schemes are not needed anymore. This causes some diffi culty in interpreting developments in wage measures like compensation per hour or per employee. disrupted by the shocks to labour supply and temporary factory shutdowns as well as lack of transportation capacities around the world, leading to an important role of bottlenecks for infl ation in goods.2 Zooming in on developments in NEIG infl ation, the rates of around 2.5%-3.0% seen since mid-2021 are well above long-term averages of NEIG infl ation (0.6%) – with supply bottlenecks and high energy costs playing an important role. Estimates based on a vector autoregression (VAR) model including a supply shock derived based on PMI supply delivery times as an indicator for supply bottlenecks and oil prices indicates that these two factors contributed around one percentage point to NEIG infl ation over the last few months (see Figure 6).3 Other factors contributing to the relatively high NEIG infl ation include the shift from services to goods demand. Turning to services, the strong recovery in infl ation has been driven especially by high-contact services, while 2 A key role of supply bottlenecks and reopening eff ects for underlying infl ation has also been observed in other jurisdictions – see e.g. Cuquerella Ricarte et al. (2022) and Koester et al. (2021c). 3 Historical decompositions are based on a VAR including a bottleneck proxy, oil prices, HICP NEIG, producer prices, industrial production, export and import volumes. The bottleneck and oil price shock are identifi ed using short-run restrictions averaged across all possible orderings of the bottleneck and oil price series. As a bottleneck proxy, a PMI supply shock is estimated from a separate VAR including PMI output and supply deliver times and identifi ed via sign restrictions. Gas prices are not explicitly included in the model, but oil prices are highly correlated with gas prices, and thus capture a major part of the energy shock. Figure 6 Decomposition of NEIG infl ation – the impact of pandemic-related eff ects annual percentage change and percentage point contributions Note: All series are demeaned. Latest observations: January 2022. Sources: Eurostat, NIPE and ECB staff calculations. Figure 7 High-contact and low-contact services infl ation annual percentage change, at constant 2020 weights; percentage point contributions Note: Series are shown with constant 2020 weights. Latest observation: December 2021. Sources: Eurostat and ECB staff calculation. -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 Jan. 2020 Jul. 2020 Jan. 2021 Jul. 2021 Jan. 2022 PMI supply shock Oil price shock Other Actual -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Jan. 2020 Jul. 2020 Jan. 2021 Jul. 2021 Low-contact HICP High-contact HICP Services HICP Feb. 2022 ZBW – Leibniz Information Centre for Economics 73 Forum The pandemic led to a fall in longer-term infl ation expectations in the euro area to historically low levels in 2020. During 2020, long-term survey-based infl ation expectations based on the ECB Survey of Professional Forecasters (SPF) stayed at a narrow range of 1.64%-1.67%. Since the beginning of 2021, longer-term infl ation expectations have been moving up, indicating that long-term infl ation expectations across a range of measures have re-anchored at the ECB’s infl ation target. This is refl ected, for example, in the ECB’s Survey of Professional Forecasters (SPF) for the fi rst quarter of 2022 (which was conducted in the second week of January) and the January 2022 Consensus Economics forecasts, in which longer-term infl ation expectations have risen to 2.0% and 2.1% respectively, up from 1.9% in their respective previous survey rounds (Figure9). This should also contribute further to underlying infl ation and help headline infl ation to settle durably at the 2% target of the ECB. Looking ahead, it will be key to closely monitor the potential eff ects of the current spike in infl ation on the evolution of indicators of longer-term infl ation expectations in particular. This is even more important given the fi nding that households’ infl ation expectations tend to be infl uenced strongly by the prices of goods that they purchase frequently (D’Acunto et al., 2022) such as fuel and groceries – which currently record very high infl ation rates. The outlook for infl ation in the euro area Over recent months, headline infl ation has soared signifi cantly, refl ecting mainly a sequence of energy price Therefore, signals from indicators of negotiated wages, which have not been directly aff ected by developments in hours worked or the recording of benefi ts from job retention schemes introduced in response to the pandemic, are especially important at the current juncture (Koester et al, 2020). Growth in negotiated wages remained moderate in the fourth quarter of 2021, standing at 1.5%, up from 1.4% in the previous quarter and averaging 1.5% over 2021 as a whole, down from 1.8% in 2020. Looking ahead, one key question is to what extent the current surge in infl ation will also push up wage demands and wage agreements in the euro area (in the form of so-called second-round eff ects). While the prevalence of formal and informal wage indexation to infl ation has been reduced since the global fi nancial crisis and is only relatively limited in the euro area (Koester and Grapow, 2021), high infl ation is still likely to be an important aspect for wage negotiations. In this context, a recent ECB survey of large European companies indicates that wage growth in 2022 could be somewhat stronger, with some respondents citing the current high levels of infl ation as a contributing factor (Gareis et al., 2022; Lane, 2022). Over the medium to long term, infl ation expectations play a key role in the achievement of a central bank’s infl ation target. Infl ation expectations that are fi rmly anchored in line with the infl ation target support the achievement of that goal by guiding wageand price-setting decisions in the economy. Deviations of infl ation expectations from the infl ation target may become self-reinforcing (Eurosystem work stream on infl ation expectations, 2021). Figure 8 Breakdown of compensation per employee into compensation per hour and hours worked annual percentage changes Note: The latest observations are for the fourth quarter of 2021. Sources: Eurostat and ECB calculations. 1.4 1.6 1.8 2.0 2.2 2.4 2001 2005 2009 2013 2017 2021 Consensus Economics "top-down" (5 years ahead) SPF (4-5 years ahead) -4 -3 -2 -1 0 1 2 3 4 -16 -12 -8 -4 0 4 8 12 16 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2019 2020 2021 Hours worked per employee Compensation per hour Compensation per employee Negotiated wages (right-hand scale) Figure 9 Survey-based indicators of infl ation expectations annual percentage changes Note: Latest observations: The Survey of Professional Forecasters for the fi rst quarter of 2022 was conducted between 7 and 13 January 2022; long-term forecasts from Consensus Economics were released on 13 January 2022. Sources: Consensus Economics and ECB Survey of Professional Forecasters. Intereconomics 2022 | 2 74 Forum scenario and a severe scenario, however, expect substantially higher infl ation in 2022 and 2023 but a moderation of infl ation to 1.9% (in the severe scenario) or even 1.6% (in the adverse scenario) in 2024 (Figure 10). Looking further ahead, structural changes are likely to play an important role for infl ation in the euro area.4 Climate change and climate policies in particular are likely to impact energy prices, changes in relative prices and the dynamics in overall infl ation. The overall impact is subject to high uncertainties in terms of sign, size and timing. The Russian war in Ukraine has increased this uncertainty even further. Until around the end of this decade, upward pressures on consumer energy prices and increased energy price volatility are possible, mainly due to higher taxes and enduring high dependence on fossil fuels. Around the end of this decade, upward pressure might ease, especially for electricity prices as the share of renewables in electricity production is expected to grow fastest. For transport and heating, fossil energy sources will still dominate beyond this decade and changes in energy commodity prices will continue to have a signifi cant impact on HICP energy infl ation. Yet, their relative importance should gradually decline with increasing electrifi cation based on renewable sources and increasing energy effi ciency. There is hope that the Russian war on Ukraine could expedite the energy transition in Europe leading to a new and more environmentally sustainable steady state. 4 See also the discussion in part 5 of Koester et al. (2021b). shocks, but also global supply bottlenecks and re-opening eff ects have contributed to infl ationary pressures. These turned out to be more persistent than previously expected by most forecasters. Still, these factors are assessed to be the result of transitory disturbances and pandemic-related adjustments and, hence, are expected to fade over the coming years. While the Russian war in Ukraine has intensifi ed the uncertainty on energy prices, oil and gas price future curves suggest a decline in energy prices, which implies sharp declines in energy infl ation looking ahead. Similarly, global supply disruptions might increase in the near term, again due to shortages of key inputs from Russia, and only fade later easing the pressure on non-energy industrial goods infl ation. As more and more containment measures are lifted across Europe, price pressures in high-contact services are likely to ease. The Russian war in Ukraine might have some dampening eff ects on infl ation via the negative growth eff ect on underlying infl ation in the euro area, but these are likely to be off set by indirect eff ects from the higher energy prices triggered by the confl ict. So, while infl ation in the euro area is expected to stay high this year as infl ationary pressures have broadened and become more persistent, infl ation is likely to stabilise at 2% in the medium term. This is also refl ected in the latest ECB (2022) staff projections – in which the baseline foresees infl ation equal to 5.1% in 2022 before falling to 2.1% in 2023 and 1.9% in 2024. An adverse Figure 10 Euro area HICP outlook – baseline, adverse and severe scenario annual percentage change Note: The panels show the baseline, adverse and severe scenarios of the March 2022 ECB staff macroeconomic projections for the euro area. Sources: Eurostat, Consensus Economics and ECB staff calculations. 0 1 2 3 4 5 6 7 2019 2020 2021 2022 2023 2024 Baseline scenario 0 1 2 3 4 5 6 7 2019 2020 2021 2022 2023 2024 Adverse scenario 0 1 2 3 4 5 6 7 2019 2020 2021 2022 2023 2024 Severe scenario February Consensus Economics mean forecast March Consensus Economics mean forecast March 2022 Macroeconomic Projection Exercise ZBW – Leibniz Information Centre for Economics 75 Forum References Bobeica, E., B. Hartwig and C. Nickel (2021, 20 August), The euro area Phillips curve: Damaged but not dead, VoxEU. Cuquerella Ricarte, S., G. Koester and R. Gomez Salvador (2022), Recent infl ation developments in the United States and the euro area – an update, ECB Economic Bulletin, 1. D’Acunto, F., U. Malmendier and M. Weber (2022), What Do the Data Tell Us About Infl ation Expectations?,Chicago Booth Paper, 22-09. Dias da Silva, A., M. Dossche, F. Dreher, C. Foroni and G. 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