Dhe inflation in the euro zone, which soared to 3 percent in August, is likely to rise even further in the course of the year: Nevertheless, monetary policy must not overreact now – that is the biggest challenge for the central bank at the moment, said Christine Lagarde, President of the European Central Bank (ECB), on Tuesday at the opening of the two-day ECB forum on monetary policy.
The annual event, which has been the counterpart to the US Federal Reserve Conference in Jackson Hole since 2014, is now being hosted online for the second year in a row.
Atypical economic recovery
Lagarde argued that there is currently an “atypical recovery” of the eurozone economy from the recession, which is leading to an increase in inflation rates. Usually, the depth of a recession determines the speed at which one can get out of the crisis. After the financial crisis, for example, it took seven years for economic output to return to pre-crisis levels. This time it goes much faster: “We are assuming that the gross domestic product of the euro area will exceed the pre-crisis level by the end of this year – three quarters earlier than we had forecast last December.”
This recovery process is currently causing supply bottlenecks and driving inflation, whereby so-called base effects such as the extremely low oil price last year and the lowering and raising of VAT in Germany played an important role. But one has to keep an eye on whether these bottlenecks may last longer than currently expected and whether they have an impact on wage developments and inflation expectations.
In addition to these temporary effects, which led to a temporary rise in inflation, it is possible that the pandemic could also trigger or intensify structural changes. “We have a decade of strong disinflationary forces behind us that have dampened the entire inflation process,” said Lagarde: “Structural changes could now exert both upward and downward pressure on prices.”
Consequences of the digitization surge for inflation
She gives a few examples: For example, digitization, which got a boost during the crisis that would otherwise correspond to a development over seven years, could trigger a second wave of globalization based on the “virtualization” of services. It could lead to higher productivity and thus dampen the rise in unit labor costs. And it could also shift economic activities to digital “superstar” companies – which have considerable market power and therefore whose pricing is less cyclical.
Conversely, the supply bottlenecks could cause companies to diversify their supply chains or relocate part of their production abroad, said Lagarde. “That was the case with previous pandemics such as SARS.” This process could lead to structures with higher costs in which “resilience”, that is, resilience in crises, takes precedence over “efficiency”, that is, profitability. The higher costs could be passed on to consumers.
At the same time, rapid digitization on the labor market could lead to a mismatch between the supply and demand for qualifications, which would result in wage increases even if the lulls persist. “It is estimated that the rate of job relocation in major economies will double between 2019 and mid-2022,” Lagarde said. This dynamic could be reinforced by a new focus on inequality – and lead to upward pressure on wages via rising minimum wages.
Effects of climate protection on inflation
Last but not least, climate policy, the “green transformation”, could have an impact on inflation, said the ECB President. “The pandemic has given a boost to green change.” This could lead to an accelerated rise in auction prices in the EU emissions trading system, the introduction of further CO2 prices and a mechanism to adjust carbon limits: “All of this could have a direct inflationary effect.” There are estimates that the green transformation as a whole will raise inflation by one percentage point for a transitional period before returning to its old path.
The green conversion will also make the transfer of energy prices more complex. The recent rise in natural gas prices suggests this. In any case, this increase is in part due to the unusually low wind energy production in Europe this summer and the need to fill the gap with conventional energy sources that can be mobilized quickly. “This in turn has implications for other industries that rely on natural gas, such as fertilizer production,” said Lagarde. “And that in turn has an impact on industries that rely on by-products of fertilizer production, such as food packaging.”
In any case, it will no longer be enough for monetary policy in the future to track the oil price: “We will also have to understand the entire energy mix.”
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