William De Vijlder

According to Eurostat‘s flash estimate, January inflation in the euro area is 5.1 percent. Inflation has moved in a space of two years from being too low to being too high compared to the objective of the ECB but the same applies if you look at US data. Inflation has become public enemy number one, it is putting pressure on governments in terms of what are they going to do about it to alleviate the burden of inflation on the purchasing power of households. It is also putting pressure on central banks: when are they going to act? To understand the dynamics and to try to have a view on how it will evolve going forward, it is useful to distinguish between three phases of the inflation developments.

Phase number one is what you could call the inflation impulse or the inflation shock. This is really the story of 2021. This is an environment where economies have been leaving the restrictions, have left lockdown, where massive support have been provided by fiscal policy but also monetary policy to households, to companies and demand has seen a big rebound.  A big rebound, supply being inelastic, that means that is putting upward pressure on prices.  In addition, importantly, there has been a shift in demand. In the United States for instance, the shift has been very visible, where, relatively speaking, households have spent less on services, less on tourism, less on restaurants because of travel restrictions and mobility restrictions but have used their money to spend more on consumer goods and consumer durables. And that has put upward pressure on that segment of the economy. Increased expenditures of consumer goods also mean that you need to transport them and a lot of them have been imported from Asia and from China so that has put pressure on the supply chains. In addition, other factors of supply disruption have played a role and that has contributed to an increase in prices. And finally, on the supply side it is also noteworthy to see that there have been massive changes in the labour market. People who have lost their job during lockdown have actually taken the time to reflect upon things and to say “well I want to work in another sector” so that means that in certain sectors there has been very quickly an emergence of major bottlenecks with insufficient labour force being available. This is typically something that you observe in the restaurant sector, in hotels but also in other sectors and that has put upward pressure on wages. Gradually the inflation dynamics have spread throughout the economy and we observe that elevated inflation has now become very broad-based and that is because there have been second rounds effects, , that is phase two of the inflation dynamics.

In the second round effects, two factors play a very important role: wages and sales prices by companies. Looking at wages, the labour market shortages have also spread and are really visible throughout the economy. You see that in the US, but you also see that in the euro area where shortages of staff in construction, services, and manufacturing are reaching record levels. Inevitably, this is putting upward pressure on wages and that will continue in the next several months, but it is also reflecting an increase in the negotiation power of workers: they can now go to see their employer and say they would like to have a higher reward for their efforts. In the United States, this has led to record high levels in terms of voluntary departures:  the quits ratio  is just a manifestation of the fact that a lot of people say: “well I can make money elsewhere so I’m going to change jobs.”  The extent to which these higher wages are having an impact on company pricing behaviour depends to some degree on what happens to productivity. Because we are in a strong recovery, it means also that typically productivity is also on the rise. So this is actually, to some degree, cushioning the companies from the impact of high wage costs. But there’s only a partial cushioning so nevertheless it still has an impact on them. Actually it forces them to reconsider the prices of the projects and services that they sell. Another reason which is pushing them in that sense is, of course, that other inputs have also become more expensive: raw materials, commodities or semi-finished products. The possibility of companies to raise their prices depends on the demand environment, and as explained before, the demand is very intense. That means that companies are now benefiting actually from a high level of pricing power. Another way to put it is that the price elasticity of demand has become very low because people are really very keen to spend their money and to actually benefit from the fact that the labour market prospects are looking better and that they are having higher wages. It is important however to keep in mind that all these parameters which I’ve mentioned: what is happening to productivity, the negotiation power of workers, the pricing power of companies and the price elasticity of demand, all these factors are conditioned by the growth environment so gradually speaking in the next several quarters, what we will see is that growth will slow and that means that the negotiation power will start to decline; that the pricing power will also wane and that price elasticity of demand will increase. That means that these changes in the parameters will act as a kind of a disinflationary force.

The third phase should become visible in the course of this year. We can call it the long and difficult road towards normalization, towards converging back to the target level of inflation set by central banks.  To illustrate this point when you look at the Bloomberg consensus for US inflation at the end of this year, the Bloomberg consensus is of the view that inflation should be at 3.1 percent, whereas in the euro area the same consensus of economists has a number of 1.8 percent. So people really expect that inflation will go down in the course of this year. One technical factor behind that dynamic is the base effects of course. But what are the other factors that will play a role? The first factor is what you could call an endogenous development, a spontaneous development and that is related to the fact that inflation is actually acting as a headwind to demand.  It’s actually weighing on the demand dynamics because  purchasing power of households is impacted by high inflation. So when demand is becoming less dynamic, it means that eventually the pressure on product and services markets will go down.It is acting as kind of a disinflationary force. Another element that plays an important role in bringing back inflation on the right path is that inflation expectations in financial markets remain well-anchored and that’s also an important development.  Then you also have the action of central banks which certain banks are really getting ready, at least as far as the US is concerned, and the Bank of England has already started to do something about these elevated levels of inflation. The Federal Reserve has taken a very important change of direction since the month of december. It has become far more hawkish and it is now putting in perspective several rate hikes in the course of this year and starting in the month of March. At the same time, it is also insisting on the fact that this policy is going to be data-dependent, it will depend month after month on how the data evolve. Then you may wonder why there is that insistence on the data dependency?  It reflects a huge degree of uncertainty, you could almost call it “discomfort” of the central bank. Discomfort about not making the error of doing too much, avoiding the”bridge too far” phenomenon, avoiding committing an overkill. Because if that were to be the case, growth would actually slow down abruptly and you could even imagine ending up in a recession and given the low level of interest rates, central banks would be ill-equipped to do something about it, hence this cautious attitude. So tightening, but at the same time monitoring the data very closely. You see the same cautious attitude if you look at  the European Central Bank that has been insisting on the need to maintain optionality and if it is necessary to even ease further. That is highly unlikely but in any case to weight how the economy reacts to the supply shock of higher energy prices, higher commodity prices and so on before deciding to move interest rates. Nevertheless, we do expect that in March next year, the European Central Bank will also proceed with the first interest rate hike. All these dynamics  are going to depend a lot as well on what is happening to energy prices. Remember that energy prices have played a key role in explaining why inflation has jumped so much and they will continue to play a very important role in the next several months in the inflation dynamics. Our commodity specialists are of the view that energy prices could still move slightly higher so that means that they would not act as a big disinflationary force and clearly it is a factor that we will need to continue to monitor very closely in our assessment of the inflation outlook.