William De Vijlder

Over the past two years, the world economy has suddenly moved from too little to too much inflation. Three phases can be distinguished. The first phase concerns the inflation impulse, which was driven by four factors: an increase in demand, a reallocation of demand, supply bottlenecks and a shift in the sector preferences of the labour force. These factors caused important changes in relative prices as well as a jump in inflation. In phase two, second-round effects enter into force. Wage growth increases and elevated inflation becomes broad-based. Key conditioning factors are negotiation power of the labour force and pricing power of companies. Both depend on the growth environment. In phase three, ‘natural’ forces such as slower growth can weigh on inflation but the prominent role is taken by central banks. They prefer to tread carefully, seeking to avoid premature or excessive tightening. Their task is complicated because at the current juncture inflation is to a considerable degree caused by a shock in energy prices. More than anything, they hold the key for the future development of inflation.

The current business cycle is atypical and this influences the analytical approach, with a focus on the supply side and whether it will be able to meet the level of demand in the economy, rather than on the demand side. Supply side disruption has been a key issue but recent PMI data suggest that we may have seen the worst. In the euro area and the US, the percentage of companies that are confronted with rising input prices and are contemplating to increase their output prices has started to decline and delivery lags are shortening. The Federal Reserve of New York’s global supply chain pressures index seems to have peaked. However, anecdotal evidence suggests visibility remains very low. Given the importance of supply disruption for the growth and inflation outlook, it implies that forecast uncertainty will remain very high. 

20 years ago, on 1 January 2002, the biggest cash changeover in history took place when 12 EU countries introduced euro banknotes and coins. Today, the euro is the currency of 19 EU countries and more than 340 million people. It benefits from a high degree of popular support. Since its launch, the euro has gone through different phases: a first decade with good growth but increasing imbalances; the sovereign debt crisis; the years of disinflation and finally the Covid-19 pandemic. Looking ahead, important challenges remain: the project of launching a digital euro, finalising banking union and making significant progress towards a capital markets union. In addition there is the need to reform economic governance, which is big challenge. In the nineties, huge adjustment efforts were undertaken under external pressure, the argument being that they were necessary to be able to join the euro. Now, the euro area countries find it hard to agree on what pressure is needed to steer national policies in a direction that would benefit all.

Judging by the latest forecasts, the outlook for growth in 2022 is positive and, at some point during the year, inflation should start to decline. Uncertainty remains elevated however so there is a risk that key economic variables evolve differently than anticipated. The biggest ‘known unknown’ concerns the future development of the pandemic. Real GDP growth could surprise to the upside should inflation decline faster than expected. A tightening of financial conditions, more supply disruptions and inflation staying high for longer are the key sources of downside risk to growth.  

After last year’s sudden, deep and a-typical recession, caused by the Covid-19 pandemic, this year has also been a-typical in several respects. Supply bottlenecks and supply disruption have been dominant themes throughout the year, acting as a headwind to growth, both directly but also indirectly, by causing a pick-up in inflation to levels not seen in decades. Under the assumption that the pandemic is gradually becoming less of an issue thanks to the vaccination levels, 2022 should see a normalisation in terms of growth, inflation and monetary policy.

In his testimony to a commission of the US Senate, Jerome Powell has acknowledged that inflation is less transitory than considered hitherto, adding that, as a consequence, a faster tapering seems warranted. Despite this hawkish tone, the reaction of US Treasuries was muted. This may, amongst other things, reflect concern about how the pandemic might evolve. The new Omicron variant undeniably represents an uncertainty shock for households and companies. It comes on top of a negative supply shock that is already a clear headwind to demand. It clearly makes the task of central banks more complicated than ever when deciding how much of a monetary headwind they can create.

Companies in the euro area report record-high levels of labour shortages. These are partly cyclical in nature but structural factors also play a role. Last year’s annual investment survey of the European Investment Bank shows that the availability of staff with the right skills is the second most important factor weighing on long-term investment decisions in the EU. Structural labour shortages can weigh on potential GDP growth through its impact on capital formation, innovation and productivity. Economic and in particular education policy including vocational training and lifelong learning schemes will have to make sure that, going forward, the available skills, both in quantity and quality, fit the evolving needs.

In the euro area, business surveys report record-high staff shortages. They represent a headwind to growth and raise the possibility of faster wage growth and a pick-up in inflation. Thus far, growth of negotiated wages has been subdued but, given its historical relationship with labour market bottlenecks, an acceleration seems likely. Despite the difficulties of companies in filling vacancies, labour market slack has remained above pre-pandemic levels. This situation should improve in the coming months but whether this eases labour market tensions depends on companies’ hiring intentions. Based on recent surveys, these should remain elevated.

A recent academic paper argues that, considering the significant recent decline of consumer expectations, the US could be entering recession. However, Covid-19 complicates the interpretation of household confidence data. Fluctuations in infections play a role and the recovery from last year’s recession as well as other factors have caused a jump in inflation. Given the historically high quits rate, the weakening in household sentiment probably reflects mounting concern about the impact of inflation on spending power. Something similar has been observed in the latest consumer confidence data for France.

Although the significant increase in inflation in most advanced economies is expected to be transitory, it is necessary to focus on the potential consequences of inflation staying temporarily high for longer. Companies that hitherto have been reluctant to raise prices might do so after all, higher inflation could weigh on spending but also cause wage demands to grow, inflation expectations could drift higher, the market sensitivity to growth and inflation surprises would increase and there could be fears about a change in the reaction function of the central bank. In the coming months, investors and central banks will scrutinise data in parallel, but the former will react more quickly should inflation stay high.

Although the forecasts from the IMF’s latest World Economic Outlook paint a quite favourable picture, there is unease about the distribution of risks. Risks to real GDP growth are tilted to the downside, a key factor being new Covid-19 variants that could hit countries with low vaccination levels particularly hard. Growth would also suffer if the increase in energy prices were to continue. Inflation risks on the other hand are skewed to the upside. Supply-demand mismatches may last longer than expected and the energy shock could cause second round effects. As a consequence, there is great uncertainty about the inflation outlook. Central banks will need to be patient, waiting for inflation to trend down, but also vigilant and ready to act if necessary. Their messages will be followed closely by financial markets, which, until now, have reacted in a calm way to the increase in inflation.