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One of the most frequently asked questions for our director of macroeconomics, Lasse Sinikallas, is whether inflation is here to stay. Lasse believes inflation is likely to stick around for some considerable period of time. Find out why and get his latest analysis of the four key drivers of inflation – energy costs, supply chain disruptions, record-low levels of unemployment and government fiscal policy.
Energy markets are particularly sensitive to geopolitical events, and there has been no shortage of those in the past two years. In March 2022, the price of a barrel of oil crossed the USD$100 threshold for the first time since 2015 as a result of the compounded effect of Covid-19 and Russia’s invasion of Ukraine.
Two years earlier, Covid-19 and the disruption it caused to workforces and supply chains put a lid on US oil production. The US is a major consumer and producer of oil, contributing almost 400 million barrels of oil in late 2019, which amounts to 19% of global production pre-Covid in 2019, and making up 20% of global demand.
If US producers can avoid further disruption and return to growth this year, they’ll be able to cover some of the gap that resulted from sanctions against Russian supply. Until then, energy prices will continue to climb.
The European producer price index shows the impact of energy costs on the costs incurred by manufacturers, who’ve seen an average 20% increase in production costs since the start of 2022. This is largely due to the rising cost of energy. Wages have yet to increase in line with inflation, but when they inevitably do, that will push up production costs, too.
What makes this period of rising energy costs different from others for manufacturers; for example, when oil prices hit USD$111 in 2011? This time it’s not just energy – there are other factors at play too, adding to the overall stickiness of inflation.
Systemic supply chain weakness goes beyond the usual bottlenecks. Covid-19 stress-tested the established just-in-time practice to its limits, and it failed. The global supply chain is now going through a period of transformation as buyers and sellers strengthen weak links and shorten their supply chains to reduce their exposure to global events. At the same time, while the West seems to have moved on from Covid-19, waves of infection continue to disrupt production and supply in Asia and Australasia, where lockdown measures are more severe.
The labor market is influencing inflation in three ways.
First, high demand for skilled workers and a lack of overall supply is creating upwards pressure on wages. Unemployment figures in the euro area and the EU 27 are at their lowest levels in nearly 25 years. And in the US, with the exception of January-February 2020 and September 2019, lowest since late 1969.
Second, the European workforce is at its biggest since measurement began in 2009.
Third, consumers, particularly in Europe, have become unused to periods of inflation. Falling purchasing power will see consumers pressure their employers to increase wages. And they are in an advantaged position to do so, given the lack of supply of skilled workers to replace them.
The euro, which has been around for about 20 years, has never seen true inflation. In the past, before the single currency, governments managed inflation by devaluing local currencies – in essence, printing more money. Today, the European Central Bank has to make policy for a group of 19 countries, each with a unique labor market, energy policy and balance of exports and imports.
While a devalued euro could stimulate demand for exported goods, benefiting net exporters such as Germany and Ireland, it would also increase the relative cost of energy and, therefore, the cost of production.
Interest rates also have a part to play. They’ve been flat and on the floor for almost 15 years. If major European central banks were to raise interest rates by a point or so, we’d expect producer price inflation to fall in tandem with a fall in the cost of energy, raw materials and other inputs. However, an increase in interest rates would put pressure on European governments that are highly indebted to central banks – for this reason, governments are unlikely to support the move.
Covid-19 stimulus packages are a major factor in governments’ indebtedness to central banks. Until the recovery from Covid-19 is perceived to be complete, governments are likely to resist any moves that would restrain their fiscal spending – such as an increase in interest rates.
If 2010’s Greek debt crisis was the first major test of the ECB’s ability to find policy alignment across the euro zone, this could be the second.
Europe, and the euro area in particular, experienced a steep fall in 2020, followed by a period of weaker-than-expected growth in 2021. We’re forecasting another slow year in 2022 at 3.7%.
The war in Ukraine is a significant risk to the outlook. Any conflict can create significant economic upside, in the form of government spending in industry and defense that trickles down through the economy, and downside, in the form of production and logistics disruptions. So far, this conflict has been only the latter – but the former case often only comes in later stages of more drawn-out, resource-intensive wars. The economic impact of this conflict will depend on its duration, which we all hope is brief.
We started to forecast inflation back in September 2021, even before the Ukraine crisis, which has only added to Europe’s economic woes. As things stand today, we expect inflation to stick around for some time.