Iinflation is coming down. On both sides of the Atlantic, falling energy costs are a relief. Price watchers are now focusing on core inflation, a measure that excludes volatile food and energy prices, which typically rises much more slowly and is harder to bring down. Core inflation in the euro zone has been higher than in the US since October. Will the Europeans end up having a bigger inflation problem than their transatlantic counterparts?
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Every economist knows Milton Friedman’s famous quote “Inflation is always a monetary phenomenon”. But the Nobel laureate’s words don’t seem to capture current inflation trends, where post-pandemic supply disruptions, fiscal profligacy, energy shocks and labor shortages have created a nearly perfect storm that sent prices soaring. So how quickly inflation falls may depend not only on the behavior of central banks but also on how these factors—disruptions, energy shocks and rising wages—affect economies on both sides of the Atlantic.
Adding to these surprises was an extraordinary upheaval in the fundamental workings of the rich world’s economies. Covid-19 has changed the way people work, consume and live, and in the short term. The lifting of pandemic restrictions has led to a surge in demand for travel, nightlife and hospitality. On top of this, US and European governments have decided to subsidize green technologies on an unprecedented scale. Capital, production inputs and workers need to be moved to the growing part of the economy and away from the shrinking part. Until they do, the economy cannot produce enough to meet demand.
However, changing jobs or investing in new factories or software takes time. Prosperity accelerated the process. Recent research by Rüdiger Bachmann of the University of Notre Dame and colleagues shows that German workers are more likely to switch jobs during times of high demand than during recessions. Another study, using U.S. data, showed that job-hopping to a growing company significantly increases the wages of job-hopping workers. Therefore, current economic changes may generate some inflation – which may be desirable. A recent paper by Veronica Guerrieri of the University of Chicago and colleagues argues that monetary policy should tolerate higher inflation if it allows workers to find a new job during times of economic change.
Government policies in the United States and Europe have influenced the pace of adaptation to these changes. The European approach has generally been to try to freeze things in place during the pandemic. Governments on the continent have created generous furlough schemes to keep workers in their current jobs. Unlike the US, there has been no boom in durable goods consumption, supported by stimulus checks, which would require expanded production. Nor did Europe let its economy overheat to help redistribute workers and capital. If inflation in the US is the result of economic restructuring, it is likely to fall faster than in Europe once that process is complete.
Europe also has to deal with different economic shocks. The Fed’s Julian di Giovanni and colleagues show that tighter supply accounts for a larger share of inflation in 2020-21 than in the US. Wholesale gas and electricity prices started rising in the fall of 2021 and surged after Russia invaded Ukraine, with oil and coal prices not far behind. This further fuels inflation in energy-importing Europe compared to the US.
The consensus among economists is that central banks should not tighten policy excessively in response to temporary supply or energy shocks. Dealing with shocks like this is hard enough—no need to turn screws. As long as inflation expectations remain stable, this effect should fade over time. Now that supply constraints on everything from lumber to chips are easing and energy prices are falling, Europe should benefit more than the US. That is, if inflation doesn’t become entrenched.
Inflation enters the economy when workers and businesses start to believe that prices will continue to rise. In a worst-case scenario, this creates a wage-price spiral where workers and businesses cannot agree on how to divide the economic pie. In a tight, flexible labor market like the US with little collective bargaining, wage growth should quickly follow inflation. Here’s the thing: When inflation starts to rise, wage growth accelerates. As Guido Lorenzoni of Northwestern University and Ivan Werning of MIT point out in a new paper, this theoretically adds to the wage-price spiral risks of. But the United States seems to have passed the most dangerous moment. Wage growth in the country, while high, has been declining for some time, according to job site Indeed.
happy union
In Europe, wages are often determined by collective bargaining agreements.across European Union This arrangement covers about six out of ten workers. Deals typically last a year or more, meaning wages take time to adjust to economic conditions. This is great when inflation kicks in. Wage pressures did not immediately increase inflation. Unions and businesses can negotiate how to share the hit to revenues and profits. After all, the two sides will meet at the same table every year for inventory and adjustment. Since they cover most of the economy, they are justified in considering the macroeconomic impact of any deal.
But the relationship is strained. Unions are demanding extra compensation for their members amid persistently high inflation in Europe. Public sector agencies in Germany are seeking a 10.5% pay rise in the latest round of negotiations. Such delayed increases in wages are a normal feature of the economy, wages take time to adjust and are hit by supply shocks. As Lorenzoni and Mr Vining demonstrate, real wages often take a hit before recovering to where they were. But while America appears to be making progress, the Old Continent is still lagging a bit. The inflation race in Europe has a long way to go. ■
Read more from our economics column Free Exchange:
Historical warning of industrial policy in the new era (January 11)
The Fed’s Great Antihero Worth Revisiting (Dec. 20)
Potential Threats to Central Bank Independence (December 15)
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