Week in Focus 17 May 2024: Why inflation is likely to remain high

Economic Research

Why inflation is likely to remain high

The ECB and a large majority of economists assume that inflation will fall further to 2% in 2025 and that we will be back to business as usual. We do not share this optimism and expect the inflation rate to be closer to 3%. On the one hand, wage costs will continue to rise sharply in the coming year and, on the other hand, companies' scope for setting prices will increase as the economy recovers. By spring 2025 at the latest, the ECB is likely to realize that inflation has not been defeated after all and that it will have to end the cycle of interest rate cuts.

Dr. Vincent Stamer Christoph Weil

Supply bottlenecks following the coronavirus pandemic, a surge in demand due to government coronavirus aid and the energy price shock caused the inflation rate in the eurozone to rise to more than 10% in the fall of 2022. As the shocks subsided, the inflation rate fell back to 2.4% in April and the core inflation rate excluding energy, food and beverages fell from a high of 5.7% in the spring of 2023 to 2.7% most recently (Chart 1). The ECB target of 2% therefore seems within reach. The vast majority of economists and the ECB expect the inflation rate to reach this target again next year.

Higher wage costs push prices up again

However, since the beginning of the year, prices have increased again from month to month. In the first three months of the year, the seasonally adjusted consumer price index excluding energy and food (core index) rose by more than 3% on an annualized basis, and the less volatile 6-month rate of change has also ended its downward trend and is now trending upwards again. This is due to the renewed sharp rise in service prices, while prices for goods (excluding energy and food) have stabilized. The price trend in the individual product groups suggests that the rise in the core index in the second half of last year was also slowed by the indirect effects of lower energy prices. This effect appears to have run its course, meaning that other drivers such as the sharp rise in wage costs are now once again dominating the price trend, which is particularly evident in labor-intensive services.

Chart 1 - Underlying price pressure increases again

Consumer price index changes excluding energy, food, alcohol and tobacco, seasonally adjusted, annualized changes, in percent

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6
5
4
3
2
1
0
-1
-2
2020	2021	2022	2023	2024
	3-months	6-months		12-months

Source: Eurostat, ECB, Commerzbank-Research

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Scarce labor force drives wages

This boost from wage costs is likely to continue. The collective wage agreements already in place suggest that collectively agreed wages will increase by an average of more than 4% over the remainder of this year (Chart 2). As in the past two years, wages actually paid are likely to increase even more strongly. The ECB expects salaries per employee to rise by 4.5% in the current year.

Chart 2 - Continuing wage increases

ECB wagetracker with and without one-offs, in percent as compared to previous year, ECB forecast dotted

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4
3
2
1
0
2020	2021	2022	2023	2024

ECB wagetracker without one-offs		ECB wagetracker incl. one-offs

Source: Eurostat, ECB, Commerzbank-Research

In the coming year, wages are also likely to increase significantly more than in the years before the pandemic, even if the lower inflation rate will probably remove an important driver. This is because the negotiating position of employees remains good. A large number of companies are complaining about a shortage of qualified workers, even if their share has fallen slightly over the past year and a half due to the weak economy. As the economy picks up, the shortage of workers is likely to increase again (Chart 3).

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Chart 3 - Labor scarcity is increasingly a problem in the euro area

Share of surveyed companies, in percent

35
30
25
20
15
10
5
0
2000	2002	2004	2006	2008	2010	2012	2014	2016	2018	2020	2022	2024

Source: European Commission, Commerzbank Research

The ageing population is likely to contribute to this more and more. Over the next ten years, this will not only lead to a noticeable reduction in the supply of workers, but will also significantly increase the demand for labor-intensive services such as care for the elderly and healthcare. It is no coincidence that employment in these areas in particular has risen significantly over the past two years. Together, these two effects are likely to further exacerbate the shortage of labor and thus push up wages.[1] The economic upturn should also make it easier for companies to pass on higher wage costs to their customers.

Below average productivity improvement

Rising wage costs would, however, have less of an impact on inflation if they were offset to a considerable extent by higher productivity from the companies' perspective. In its inflation forecast for 2025, the ECB assumes a strong increase in labor productivity of 1.2%, which would be twice as high as the long-term average. We believe this is too high. It is true that productivity increases more strongly at the start of an upswing because companies are better able to utilize their employees (Chart 4). However, the complaints about labor shortages suggest that the workforce is already well utilized at present. The scope for increasing productivity is therefore likely to be less than at the start of previous upturns and therefore less of a brake on the rise in unit labor costs. The use of artificial intelligence (AI) is also unlikely to be a cure for the anemic productivity trend: We assume that it will be a long time before AI will noticeably increase productivity.

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Economic Research

Chart 4 - Labor productivity will rise only little

Labor productivity per employee, real GDP, changes over previous year in percent

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4
2
0
-2
-4
-6
99	00	01	02	03	04	05	06	07	08	09	10	11	12	13	14	15	16	17	18	19	20	21	22	23

Gross Domestic Product		Labor productivity

Source: Eurostat, Commerzbank-Research

Deglobalization and decarbonization as additional price drivers

There are also a number of structural factors that will push up inflation in the medium term. One of them is the deglobalization that is becoming more apparent. More and more countries are erecting new trade barriers, most recently the USA with massively higher tariffs on some Chinese products, and want to reshore the production of important products in order to be less dependent on foreign suppliers. An ECB study concludes that inflation will be 0.15 percentage points higher given the current trend of fragmentation in global trade.

The intended decarbonization of the economy will also cause prices to rise faster. A CO2 price already applies to the energy sector and the manufacturing industry. From 2026, this will be supplemented by the "Carbon Border Adjustment Mechanism" (CBAM), which taxes imports of goods for which producers did not pay a CO2 price. While these effects directly increase prices, the conversion of industry to environmentally friendly technologies also has an indirect effect: companies are forced to replace their machines earlier than they would otherwise have done. These additional costs will also ultimately have to be borne by consumers. According to a study by the IMF, the energy transition alone could generate inflationary pressure of at least 0.2 percentage points per year in the eurozone, assuming that the goals of the Paris Agreement are implemented. This inflationary pressure complements the effects mentioned above.

ECB cannot cut key interest rates too much

Inflation in the eurozone may therefore decline somewhat in the coming months, as expected by the ECB. However, the rate of inflation should gradually pick up again later this year. Accordingly, like most other observers, we assume that the ECB will cut key interest rates by a total of 75 basis points by the end of 2024. At the beginning of 2025, however, it is likely to become increasingly

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clear that the inflation problem has not been solved, which will limit the scope for further interest rate cuts. For 2025, we therefore only expect a rate cut of 25 basis points in March.

1. In a study, the ECB calculates that the inflation rate will be around half a percentage point higher on average in the coming years than would otherwise have been the case due to demographic change. (back)

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In accordance with ESMA MAR requirements this report was completed 17/5/2024 07:16 CEST and disseminated 17/5/2024 07:16 CEST.

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