Why high inflation has emerged in the eurozone

Euro­zone infla­tion is more wor­ry­ing and prob­a­bly more sus­tain­able than US infla­tion. Infla­tion – exclud­ing ener­gy and food (core) – is still equal to 5.5% in the Unit­ed States in the spring of 2023, but the US mea­sure of infla­tion is unusu­al in that it gives an extreme­ly high weight­ing (38% in core infla­tion) to actu­al rents and rents charged to homeowners.

This item is up by 8% year-on-year, but we can expect a fair­ly sharp fall in rent increas­es in the sec­ond half of 2023, dri­ven by the fall in house prices. If we look at infla­tion exclud­ing ener­gy, food, and rents in the US, it has fall­en from almost 8% at the start of 2022 to 3.8% in April 2023. US infla­tion will con­tin­ue to fall, because growth is weak (below 1% in 2023), because the labour mar­ket is eas­ing a lit­tle, and because wages are slowing.

The US infla­tion sit­u­a­tion is very dif­fer­ent from that of the euro­zone. The rise in rents has remained rel­a­tive­ly low in the euro­zone (2.9% over one year) and despite this, infla­tion exclud­ing ener­gy and food reached 7.3% in April 2023, more than 4 points high­er than infla­tion exclud­ing ener­gy, food, and rents in the Unit­ed States.

There are three rea­sons for this con­sid­er­able dif­fer­ence in infla­tion rates between the euro­zone and the Unit­ed States. First, stronger wage increas­es (5½% expect­ed in the first quar­ter of 2023 in the euro­zone, com­pared with just over 4% in the US). Sec­ond­ly, a rise in cor­po­rate prof­it mar­gin rates since the start of 2021, which has added 1 ½ points a year to infla­tion, where­as cor­po­rate prof­it mar­gins have been falling in the US since the start of 2021, instead reduc­ing infla­tion by 1½ points a year over this period. 

Final­ly, the fact that mon­e­tary pol­i­cy is clear­ly more restric­tive in the Unit­ed States: the Fed Funds inter­est rate is 5¼% with under­ly­ing infla­tion includ­ing rents of 5.5%; in the euro­zone, the repo rate (the refi­nanc­ing rate) is 4¾% with infla­tion exclud­ing ener­gy and food of 7.3%; rel­a­tive to infla­tion, the ECB’s key inter­est rate is 300 basis points low­er than that of the Fed­er­al Reserve, which favours the main­te­nance of high infla­tion in the eurozone.

We can there­fore con­clude from observ­ing recent devel­op­ments that the risk of main­tain­ing high and last­ing infla­tion is much high­er in the euro­zone than in the Unit­ed States. But we need to under­stand the mech­a­nisms that have caused this high infla­tion in Europe.

It is instruc­tive to take as a start­ing point a very inter­est­ing sur­vey of Euro­pean busi­ness­es con­duct­ed by the Euro­pean Com­mis­sion, which looks at the fac­tors lim­it­ing pro­duc­tion in indus­try and ser­vices. From 2010 to 2016, the main fac­tor lim­it­ing out­put was insuf­fi­cient demand. We are then in a so-called « Key­ne­sian » regime: if there had been more demand, com­pa­nies would have been able to pro­duce more. The sys­tem of insuf­fi­cient demand reap­pears tem­porar­i­ly in 2020 due to the Covid crisis.

But from 2017 to 2019, and then from 2021 to the present day, the rea­sons for lim­it­ing pro­duc­tion are com­plete­ly dif­fer­ent. Com­pa­nies no longer cite insuf­fi­cient demand, but rather insuf­fi­cient equip­ment and hir­ing difficulties.

The caus­es are con­sis­tent with trends in busi­ness invest­ment and the labour mar­ket in the euro­zone. The rate of busi­ness invest­ment in the euro­zone fell con­sid­er­ably in 2008 and 2009 with the sub­prime cri­sis and remained very depressed until 2018. It does not return to its 2007 lev­el until 2019, before falling again. This chron­ic sit­u­a­tion of under-invest­ment is very much in line with the state­ment made by com­pa­nies that it is inad­e­quate equip­ment that is caus­ing them to lose production.

Fur­ther­more, com­pa­nies’ recruit­ment dif­fi­cul­ties rise well above nor­mal from 2017 to 2019, and become extreme­ly high in mid-2021, and remain so today. The ratio of the num­ber of job vacan­cies to the num­ber of unem­ployed (known as the Bev­eridge ratio) ris­es from 0.15 in 2016 to 0.30 in 2019 and 0.50 in 2022 and ear­ly 2023: it is there­fore under­stand­able that com­pa­nies should cite recruit­ment dif­fi­cul­ties as the cause of lost production.

Since 2017, and with the excep­tion of 2020, the euro­zone has moved from a regime of insuf­fi­cient demand to a regime of insuf­fi­cient sup­ply of goods and ser­vices (excess demand), due as much to the lack of avail­able equip­ment as to the lack of employ­ment resources. It is not sur­pris­ing then that infla­tion has appeared. In fact, if it had­n’t been for the Covid cri­sis, infla­tion would have appeared ear­li­er: wages rise by less than 2% a year from 2011 to 2016, accel­er­ate to 3% in 2019, fall back in 2021, and then accel­er­ate again from 2% to 5% a year from the begin­ning of 2021 to the end of 2022; it is the Covid cri­sis, with the result­ing fall in demand, that has delayed the appear­ance of infla­tion in the eurozone.

It is the Covid cri­sis, with the induced fall in demand, that has delayed the onset of infla­tion in the eurozone.

Infla­tion is there­fore firm­ly entrenched in the euro­zone, with the scarci­ty of equip­ment and the scarci­ty of labour. What is the out­look? Infla­tion will only fall sig­nif­i­cant­ly in the euro­zone if its econ­o­my returns to a sit­u­a­tion of insuf­fi­cient demand, as opposed to excess demand. But this is high­ly unlike­ly to hap­pen in 2023 or 2024, giv­en the stag­na­tion in labour pro­duc­tiv­i­ty and the decline in the work­ing-age population.

These two devel­op­ments mean that poten­tial growth will be very low, even tak­ing into account the rise in the employ­ment rate (the pro­por­tion of the work­ing-age pop­u­la­tion in employ­ment). In 2023 and 2024, expect­ed growth (0.8% in 2023, 1.5% in 2024) will there­fore be high­er than the growth in poten­tial out­put, and excess demand will be even greater than it is today.

The infla­tion expec­ta­tions of the ECB or the finan­cial mar­kets (infla­tion of just over 2% at the end of 2024) are prob­a­bly con­sid­er­ably low­er than the infla­tion that will actu­al­ly take place.