Inflation tends to evolve procyclically over the business cycle. A pick-up in inflation during a growth upswing is welcome news, at least initially. It signals that policy stimulus –monetary and/or fiscal- when activity was subdued has been effective in boosting activity and demand, that the re-emergence of labour market bottlenecks is creating upward pressure on wages, that companies, faced with solid demand, reflect these higher wages in their sales prices, etc. In such a world of a demand-side driven acceleration of price increases, inflation is good, at least initially. However, inflation can also be bad. In that case, higher prices do not follow from higher wages due to a tight labour market or companies, faced with strong demand, trying to charge higher prices. Bad inflation rather reflects supply-side shocks. This is, to some degree, the situation that is unfolding in the Eurozone and other major economies due to the recent huge increase of oil and gas prices, with a knock-on effect on electricity prices. Although this is in part related to strong demand, supply-side factors also play a role, leading to a huge increase in prices[1]. Bad inflation weighs on households’ real disposable income –higher prices have not been preceded by wage increases- and company profits. This may cause a slowdown of demand, triggering a countercyclical relationship between inflation and growth. Eventually, bad inflation can end up causing stagflation, in which growth is disappointingly low and inflation too high. Judging by the number of references in Bloomberg articles, stagflation worries have been on a rising trend for several years, but, with the exception of short-lived spikes, have remained low. Recently however, the topic has been skyrocketing (chart) reflecting fears that elevated input price pressures would end up dealing a blow to the growth outlook. In this respect, increased uncertainty can play a role, e.g. due to a reduced visibility about the monetary policy outlook. Bad inflation confronts central banks with a dilemma: do nothing thereby running the risk of inflation staying high for longer or tighten policy, which could weigh on growth. If the pick-up in inflation is temporary, it is justifiable not to react.  This is the line taken by the ECB as explained by Christine Lagarde: “Our new forward guidance on interest rates is well-suited to manage supply-side risks. This guidance ensures that we will only react to improvements in headline inflation that we are confident are durable and reflected in underlying inflation dynamics.[2] Another source of uncertainty which follows from the jump in gas prices are the knock-on effects on other sectors.[3] To what extent will this weigh on investment and hiring decisions? A direct and potentially more important influence is on household spending, whereby the impact differs depending on the income level. In France in 2017, 6% of spending of households in the lowest two income deciles  went to heating and 4% to fuel. The average for the top two deciles was respectively 4.2% and 3.5%[4]. Considering that the savings rate of lower income households is significantly lower than for the rest of the population, there is a higher likelihood that a big increase in energy prices would crowd-out other types of spending and weigh on GDP growth.

Edito EN 21.35

 

[1] For a recent analysis of the drivers of higher gas prices, see Tagliapietra, S. and G. Zachmann (2021) ‘Is Europe’s gas and electricity price surge a one-off?’, Bruegel Blog, 13 September

[2] Source: Monetary policy during an atypical recovery, Speech by Christine Lagarde, President of the ECB, at ECB Forum on Central Banking “Beyond the pandemic: the future of monetary policy“, Frankfurt am Main, 28 September 2021.

[3]Soaring natural gas prices have forced closures of fertiliser plants, the UK’s main source of C02 to make drinks fizzy, stun animals for slaughter and cool nuclear power plants”. Source: CO2 crisis set to spread to Europe, big distributor warns, FT, 22 September 2021

[4] Source: The expenditures of households in France in 2017, INSEE.