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.