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Euro Zone Inflation at 3.4% - Temporary Effect or Real Problem?

Engin Eroglu

Even before the Covid crisis, the European Central Bank had "stepped on the gas" with zero interest rates and quantitative easing. However, since the "Pandemic Emergency Purchase Program" (PEPP) launched in spring 2020, the ECB has now pushed this accelerator pedal to the hilt.

According to the latest inflation figures published by Eurostat last week, the expected annual inflation rate in the euro zone will rise from the most recent 3.0% to 3.4%. This figure is still well above the ECB's inflation target of 2%. According to the ECB's interpretation, this is merely a transitional phase. In this phase, according to ECB chief Christine Lagarde, it could happen that inflation is moderately above the target value. It is therefore important, in her eyes, "not to overreact " in this situation. Is this assertion justified in view of the constantly rising figures?

At first glance, there is certainly some truth to the ECB's position. The Covid crisis has led to a drop in energy prices and thus to a kind of "base effect". Compared with the low level of summer 2020, energy prices have risen by more than 15%. Energy accounts for 9.5% of the inflation rate, which is why it has a major impact on the overall inflation rate.

Germany has also reduced the VAT rate for the period from July to December 2020. This temporary measure has triggered another base effect, which has now pushed inflation in the eurozone's largest economy up to 4.1%.

At second glance, however, the situation seems less reassuring:

First, the higher price of CO2 emission allowances and their subsequent reduction is likely to be a permanent cost factor that will be reflected in energy prices for EU consumers.

Second, the Corona crisis has shown that globalized supply chains entail additional risks for companies and economies. It is to be expected that both the private sector and governments will implement strategies to relocate production facilities. In any case, this will make products more expensive for customers and thus fuel inflation.

Third, we are still experiencing the effects of previous ECB measures. These include an increase in M3 money supply averaging 4.5% per year since 2010, which is well above the interest rate and above economic growth. The increase is even more dramatic for total assets held by the ECB. These have more than quadrupled since 2010. The ECB's low interest rates have also led to a boom in the housing and construction markets, with shortages of labor and materials additionally driving up prices. The rise in these prices generally occurs with a time lag, so these prices are likely to continue to rise for some time.

Fourth, the economy has gained momentum and is catching up after a difficult pandemic period. High order backlogs and capacity bottlenecks are raising prices.

Fifth, labor costs could rise for several reasons: Higher minimum wages in several EU member states are politically likely. Higher wage settlements triggered by "temporary" inflation increases are already on the horizon. In addition, the baby boomer generation is retiring, reducing labor supply. All these effects could even trigger a wage-price spiral.

Sixth, public debt increased during the Corona crisis, limiting the ECB's room for maneuver in practice.

Last but not least, higher inflation itself could be an additional driver. Carmen Reinhart, Vice President and Chief Economist at the World Bank, for example, warns against not taking the threat of inflation seriously enough. The longer the period of elevated inflation lasts, "the more it influences inflation expectations. And the more it affects expectations, the longer it will take for inflation to come down." In this sense, inflation is - to some degree - a self-fulfilling prophecy. Reinhart therefore believes that inflation will be more permanent than thought.

To summarize: Yes, there are arguments that the increased inflation is only "temporary." However, there are growing indications that it could last longer. Given the uncertainties of the pandemic, it is understandable if the ECB does not want to hit the monetary brakes hard. Nevertheless, it is now time to slowly take the foot off the gas pedal.

Engin Eroglu
Freie Wähler MEP