Iinflation is coming Low. On both sides of the Atlantic, falling energy costs are breathing a sigh of relief. Price watchers are now focusing on core inflation, a measure that excludes volatile food and energy prices and typically rises much more slowly — and is harder to bring down. Since October, core inflation in the euro zone has been higher than in America. Could Europeans end up with a worse inflation problem than their transatlantic counterparts?
Every economist knows Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon”. But the Nobel laureate’s words don’t seem to capture the current inflationary spree, in which post-pandemic supply disruptions, fiscal excesses, an energy shock and labor shortages have unleashed a near-perfect storm that’s sending prices skyrocketing. So how quickly inflation falls may depend not only on what central banks do, but also on how those factors – the disruptions, the energy shock and wage increases – affect economies on both sides of the Atlantic.
Alongside these surprises, there has been extraordinary turbulence in the basic operations of rich-world economies. Covid-19 changed how people work, what they consume and where they live, and in a short space of time. The lifting of pandemic restrictions then led to a surge in demand for travel, going out and treats. In addition, governments in America and Europe have decided to subsidize green technologies on an unprecedented scale. Capital, means of production and labor must be shifted into growing parts of the economy and away from declining parts of the economy. As long as this is not the case, the economy cannot produce enough to meet demand.
But moving jobs or investing in new systems or software takes time. A boom speeds up the process. Recent work by Rüdiger Bachmann of the University of Notre Dame and colleagues shows that workers in Germany are more likely to change jobs when demand is high than during recessions. Another study using American data suggests that moving to a growing company significantly increases pay for the job-changing worker. The current changes in the economy should therefore lead to some inflation – and that may be desirable. A recent paper by University of Chicago’s Veronica Guerrieri and colleagues argues that monetary policy should tolerate slightly higher inflation if it allows workers to find new jobs in times of economic change.
Government policies in America and Europe have affected the pace of adjustment to these changes. Europe’s approach has generally been to try and freeze things during the pandemic. The continent’s governments created generous furlough policies that kept workers in their existing jobs. Unlike America, there was no stimulus check-funded consumption boom in durable goods that required an expansion of production. Nor has Europe overheated its economy to encourage a redistribution of labor and capital. If America’s inflation is the result of economic restructuring, it may fall faster than Europe’s once that process is complete.
Europe also suffered another economic blow. The Federal Reserve’s Julian di Giovanni and colleagues show that supply shortages were a larger contributor to inflation in 2020-21 compared to America. Wholesale gas and electricity prices started rising in the fall of 2021 and surged after Russia invaded Ukraine, followed by oil and coal prices. This contributed much more to inflation in energy-importing Europe than in America.
The consensus in the economy is that central banks should not tighten monetary policy too much in response to a temporary supply or energy shock. Coping with such a shock is hard enough – you don’t have to turn the screw again. The impact should fade over time as long as inflation expectations remain stable. Now that supply shortages in everything from lumber to wood chips are easing and energy prices are falling, Europe should benefit more than America. Assuming inflation hasn’t solidified.
Inflation is burned into economies when workers and businesses believe prices will continue to rise. In the worst case, this results in a wage-price spiral in which employees and companies cannot agree on how the economic cake should be divided up. In a tight, flexible labor market like America’s, where there is little collective bargaining, wage growth should quickly follow inflation. And this is what happened: Wage growth accelerated as inflation began to rise. As a new paper by Guido Lorenzoni of Northwestern University and Ivan Werning of the Massachusetts Institute of Technology argues, this theoretically increases the risk of a wage-price spiral. But America seems to have made it past the point of greatest danger. According to Indeed, a job site, the country’s wage growth, while high, has been declining for some time.
Blessed Unions
In Europe, wages are often decided in collective agreements. About the EU About six out of ten employees fall under such regulations. Contracts typically last a year or more, meaning wages take time to adjust to economic conditions. That was great when inflation got going. Wage pressures did not immediately contribute to inflation. Unions and companies could negotiate how to share the blow to income and profits. After all, both sides meet at the same table every year to take stock and coordinate. Because they cover large parts of the economy, they have reason to consider the macroeconomic impact of each deal.
But relationships are feeling the strain. With inflation stubbornly high in Europe, unions are demanding additional compensation for their members. In the most recent round of negotiations, Germany’s public-sector companies are aiming for an increase of 10.5%. Such delayed wage increases are a normal feature of an economy where wages are taking time to adjust and which has been hit by a supply shock. As Messrs. Lorenzoni and Werning show, real wages usually slump before recovering to their old levels. But while America seems to be making progress, the old continent lags far behind. Europe’s inflationary race must run longer. ■
Read more from Free Exchange, our column on business:
Warnings from history of a new era in industrial policy (11th January)
The Federal Reserve’s great anti-hero deserves a second look (20th of December)
The Insidious Threats to Central Bank Independence (15th December)
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