Inflation is reaching record highs in Europe, leading to expectations of strong action from the ECB. However, the ECB is partly powerless and should not overreact to rising prices, at the risk of stifling the recovery.
Inflation has multiple causes
The surge in inflation observed since spring 2021 can be explained by several developments, the respective influences of which are difficult to assess.
One explanation is the surge in energy prices. In France, where inflation stood at 2.9% in January 2022, energy prices jumped 20%, while price increases in all other major categories of goods and services remained below 2%. The sharp rebound in global growth, as well as geopolitical tensions (Russian threats against Ukraine, drone attacks on oil facilities in the United Arab Emirates) explain the surge in energy prices.
A second explanation stems from the distortion of demand in the economy. Before the health crisis, the structural trend in the economy was to move increasingly towards services. However, the pandemic led to a sudden distortion in demand. At the end of 2021, consumption of electrical and electronic products was 8% higher than its pre-crisis level, while consumption of services such as transport and accommodation/catering remained severely depressed. This is due to sudden changes in lifestyles, which have accelerated teleworking (and therefore the use of IT equipment in households) but constrained the consumption of many services. This has resulted in supply difficulties and price increases for the most in-demand products (such as microprocessors), while the price of less in-demand services has not fallen.
Finally, strong European growth is also fueling inflation. By the end of 2021, the eurozone had returned to its pre-crisis level of activity, a catch-up phenomenon that is fueling inflation through a rebound in demand (partly linked to the two previous points) but also through higher employment and wages.
Inflation that the ECB can hardly curb
Of the three main causes of inflation, the ECB has control over only one. It cannot curb energy prices by easing geopolitical tensions or slowing growth in the rest of the world. Nor does it have any influence over household consumption choices, which are primarily dictated by the consequences of social distancing measures and new consumption habits. Its main lever for action is to influence activity in the eurozone by raising its key interest rates.
This strategy is reminiscent of that adopted by Paul Volcker, who, when he was in charge of US monetary policy in the early 1980s, deliberately stifled growth in order to curb inflation, which was then exceeding 10%. Such a strategy would be particularly harsh in the eurozone today, as it would only address one of the three identified causes of inflation. To have a tangible effect, monetary policy would have to be tightened to the point of triggering a very severe recession.
While current inflation undoubtedly poses problems for household purchasing power, the remedy needed to curb it would likely prove worse than the disease.
