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Europe should not worry about inflation

March 22, 2021

The euro area will see a sharp rise in prices as a vaccine-led recovery gathers steam, but there are several reasons why the inflationary trends will be short-lived and are unlikely to spiral out of control.

A wallet filled with euro currency notes
The expected economic recovery is set to push up prices of goods and servicesImage: Patrick Pleul/dpa/picture alliance

After years of struggling to push up prices to levels healthy enough to encourage firms to make investments and boost production, the European Central Bank (ECB) is now being forced to allay concerns that inflation could get out of control in the coming months.

Eurozone inflation jumped sharply in January, prompting concerns that the ECB would be forced to tighten its money taps sooner than expected even as the economy struggles to emerge for good from the worst recession since World War II.

What is fueling inflation concerns?

There are enough signs that prices of goods and services are only headed higher from here.

A sharp global recovery in demand, driven predominantly by China, is already pushing up prices of metals, food and fuel. Copper, a base metal that is used widely for anything from homes, factories and mobile phones to the transmission of electricity, is trading around its highest level since 2011. Other metals, including iron ore and nickel, are also seeing steep price gains.

Temporary shortages caused by the COVID-19 pandemic in industries such as semiconductors, steel and shipping are also threatening to fuel inflation. Business surveys suggest that manufacturing input prices are rising at their fastest pace in nearly a decade. While firms are yet to pass on the burden to consumers, they might be prompted to change course if the shortages persist.

Then there is the big elephant in the room: pent-up demand. People have been locked down in their homes for months now, resulting in them hoarding hundreds of billions of euros in cash and in bank deposits.

When lockdowns are lifted, these people are expected to go on a spending spree, eating out and setting off on vacations — a sudden jump in demand that recession-battered businesses would struggle to meet. This would lead to a situation where too many euros would be chasing too few goods, leading to an increase in prices.

An infographic showing Deutsche Bank's inflation forecast

How will ECB react to soaring prices?

The above factors are expected to drive the euro area's inflation rate past the ECB's "below but close to 2%" target.

The rise is, however, unlikely to prompt the central bank to immediately suck out excess cash from the economy, as most of the factors driving up the prices are temporary in nature and are expected to disappear once the economy normalizes, businesses return to full capacity and supply issues are resolved.

Giving some breathing space to the central bank is the job market, which remains under pressure. Tens of thousands of people have lost their jobs during the pandemic despite government job retention schemes.

Deutsche Bank expects the unemployment rate to average 8.5% in 2021 and 2022 and remain above the 7% pre-pandemic low for a few years. The jobless rate would look a lot worse if one took into account the many people who have been left searching for a job during the lockdown and the millions of unviable jobs protected by short-term work schemes. High levels of joblessness weigh down total demand for consumer goods, as households have less cash at hand to make purchases.

"Even as inflation picks up this year, additional labor market slack, weak past inflation and a focus on jobs protection at the expense of pay increases all mean that eurozone wage growth will remain subdued," said Jessica Hinds from Capital Economics. "This should reassure the ECB that the labor market will not be a source of inflationary pressure."

A rise in wages is said to prompt firms to raise the prices of their goods and services as they look to guard their profit margins.

An infographic showing GDP projections by OECD

Will all the pent-up demand be released?

Ben May, an economist at Oxford Economics, does not expect all the forced savings to be spent quickly, playing down concerns around pent-up demand.

"Most of the savings have been accrued by high-income earners who typically have a low marginal propensity to spend. Also, some of the involuntary savings buildup will have been by households that had previously saved too little. These households may prefer to hold onto their excess savings or pay down debt over going on a spending binge," he wrote in a note to clients.

People would rather spend cautiously initially amid delayed reopenings and a weaker labor market, he said, adding that consumer spending would pick up pace once normalcy returns.

How is base effect going to push up inflation?

The inflation rate that's published every month is the change from the rate recorded in the corresponding month of the previous year. Now, if the prices were abnormally low in the year-ago month, then even a small rise in prices would lead to a major jump in the rate of inflation and vice versa. This distortion is what economists call the base effect.

When the world's economy virtually came to halt last year as governments sought to check the spread of the coronavirus, consumer prices fell sharply, driven by a record slump in energy prices in March and April. The oil prices have since recovered to pre-pandemic levels, meaning they would push up the inflation rate over the next few months.

Deutsche Bank economists forecast the base effect from last year's fall in oil prices will be most pronounced in the fourth quarter, pushing headline inflation, which includes prices of volatile goods such as energy and food, to 1.8 %.

The base effect will fizzle out once more "normal" months become the basis of comparison for inflation readings.

An infographic showing that the size of fiscal support varies between countries

How does Europe compare with the US?

Inflation concerns are greater in the US than in Europe because Washington has pumped in much more cash into the economy than the eurozone. The US economy is also seen recovering at a rapid pace as its vaccination drive gathers pace. The eurozone, on the other hand, will most likely have slipped back into recession in the first quarter amid a still-raging pandemic and snail-paced vaccinations.

"The US economy is not only on the receiving end of a much larger dose of stimulus than the eurozone, but it also has less space to absorb that stimulus without generating inflationary pressures," Neil Shearing, chief economist at Capital Economics, said in a note to clients.

The Federal Reserve has indicated that it's prepared to tolerate inflation climbing up to 2.5% and would not hike interest rates anytime soon. This is in line with the Fed's move to targeting an average inflation rate of 2% over time, which means a higher rate of inflation later would only compensate for the recent low levels of inflation.

"A sustained rise in inflation only occurs if policymakers allow it. And the willingness of policymakers in the US and Europe to embrace inflation is very different," Shearing said. "One legacy of the pandemic may well be higher inflation in some countries. But when the inflation revival comes, it is more likely to be in the US than the eurozone."

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Portrait photo of Ashutosh Pandey wearing a blue collared shirt and a navy-blue blazer
Ashutosh Pandey Business editor with a focus on international trade, financial markets and the energy sector.@ashutoshpande85