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Short argument for optimistic scenario for core euro zone inflation

 

Given the arrival of first good news for euro zone core inflation, but still very uncertain outlook, it might be worthwhile to outline what would the optimistic case for euro zone core inflation look like.

The optimistic case rests one two arguments. First, some segments of core inflation should benefit from reversal of the shocks that drove prices higher last year. For non-energy industrial goods this is about lower energy prices feeding through to lower industrial good prices, and about unwinding supply bottlenecks leading to lower equilibrium prices. For services this is about price increases related to re-opening going into reverse.

While all of this is possible – I would even venture to say that the question is of magnitudes, not whether it will happen - on its own it is unlikely to inspire that much optimism. Especially, when the counterargument is that wages are increasing pretty rapidly by historical standards. And here in comes the second argument: While nominal wages are increasing at fast pace and will continue to do so, what matters for inflation outlook is the level of real wages. And the key point is that even with rapid increase in nominal wages, real wages will only come back to pre-pandemic level in 2025, as per ECB:

And in this lies the optimistic case for euro zone core inflation. It is really the counterargument for pessimist case, which is built around wages. In other words, at the heart of the optimistic case is that the argument based on wages carries much less weight than people think. Sure, ceteris paribus wages increasing rapidly implies higher inflation, but that on its own does not imply high inflation. The reason is that so far prices have increased without corresponding increase in wages, so that now wages have scope to increase without a need for prices to increase. So the optimistic case for core euro zone inflation is built around the simple argument that previous price increases that outpaced wage increases created a cushion in which effect of wage increase can be absorbed.

The other way to think about this is in terms of profits: after profits rose significantly over last 3 years, there is a large scope for firms to absorb higher wages without the need to increase prices. Again, chart on profits from the ECB:

Add to this that the lower input prices (energy and food) provide additional scope to absorb higher nominal wages even without lower profit margins - decrease in one input cost would offset increase in another input cost – and you end up with plausible optimistic case for euro zone inflation.

Ultimately, given that we will be gradually returning to pre-pandemic world in terms of external costs (energy, food, commodities and transportation), in terms of supply in our economy (cars, airlines) and in terms of demand (holidays), return of real wages to pre-pandemic world should not mean high inflation. It is just return to an old equilibrium.