Why high inflation has emerged in the eurozone
- The risk of sustained high inflation is much higher in the eurozone than in the United States.
- This is due to rising wages, higher corporate profit margins and a less restrictive monetary policy than in the United States.
- Since 2017, the eurozone has moved from a regime of insufficient demand to one of insufficient supply, which has triggered inflation.
- The causes of limited production in the eurozone: inadequate equipment and hiring difficulties.
- In 2023 and 2024, expected growth (0.8% in 2023, 1.5% in 2024) will be higher than the growth in potential output.
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.
American and French inflation: what are the differences?
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.
The causes of output restraint
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.
What is the outlook for the future?
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.