Unrelenting inflation: Will price pressures ever let up?

Supply versus demand shocks

Researchers at the Peterson Institute for International Economics developed a basic methodology to determine the magnitude of supply and demand shocks.⁷ Supply shocks could come in a variety of forms, including pandemic-related disruptions to the labor supply, factory output, and port capacity, along with diminished availability of food and energy following Russia’s invasion of Ukraine. Fiscal and monetary stimuli are the main demand shocks. Using data from the International Monetary Fund (IMF), we apply this methodology to a wider group of economies to better understand the nuances of inflation in each region. 

The results of applying this methodology show that nearly every major economy has experienced negative supply shocks since the pandemic hit (figure 2). The good news about supply-side inflation is that it can ease on its own. Indeed, pandemic-related disruptions to supply are already doing just that. For example, more people are back at work and fewer locations continue to implement lockdowns.⁸ As a result, the cost of shipping has come down⁹ and goods inflation excluding energy has moderated in numerous geographies.

Euro-area countries, where inflation is mostly due to supply shocks, should be prime beneficiaries of the easing of supply-side constraints. Unfortunately, much of the euro area’s supply shock comes from the ongoing war in Ukraine, which could last much longer. Although some food commodity prices have fallen after a deal was reached to allow Ukraine to export its grain through the Black Sea,¹⁰ energy prices remain elevated.¹¹ If energy prices remain where they are, their year-over-year growth rate will not come down much until February or March next year once base effects take hold. Even that scenario may be too optimistic as it likely hinges on there being no escalation of tensions with Russia. As of this writing, there is a risk of further disruption of the natural-gas market in Europe.

Some demand-side shocks are also beginning to ease on their own. Heightened risk of recession has lowered expectations for global growth¹² and contributed to a pullback in economic activity. Governments have also mostly ended their pandemic-related stimulus packages, creating a fiscal drag on economic growth relative to last year. A weakening of demand will benefit economies, such as the United States, where positive demand shocks are at least partially to blame for higher inflation.

Despite demand easing a bit on its own, countries that saw positive demand shocks will likely need central bank intervention to bring inflation back down to 2%. Monetary policy is reasonably effective at restraining demand drivers of inflation, though it does little to rein in supply-driven inflation. Apart from the Bank of Japan, most developed-economy central banks have begun to tighten monetary policy.¹³ The United States, which arguably experienced the largest demand shock among developed economies, has also seen some of the fastest rate hikes this year, which pushed the policy rate to between 2.25% and 2.5% in July. More rate hikes are likely to be necessary to bring inflation down further. For example, some rule-based measures of the policy rate suggest that it should rise to 9% or more depending on the rule’s specifications.¹⁴ It is unlikely that any of the developed-economy central banks will raise rates that high, but it gives some indication of how high the rates could go if inflation does not moderate soon.

Unfortunately, in economies such as the eurozone, where there is little evidence of a demand-side shock, weakening demand may do little to alleviate inflationary pressures. Consider that much of the inflation seen throughout Europe is directly tied to the spike in food and energy prices that occurred after Russia’s invasion of Ukraine. Energy prices in Europe are unlikely to come down significantly without some type of resolution in Ukraine. This puts Europe at an elevated risk of worsening stagflation, where high inflation coexists with weak or falling GDP growth.

Great expectations for inflation

In economies where supply shocks are the primary or exclusive drivers of inflation, raising interest rates will be far less effective at bringing down price growth. Despite this fact, most developed-economy central banks—concerned that inflation expectations could become entrenched—have raised interest rates. This means that, as consumers witness high inflation, they begin to expect those price gains to persist, which can lead to behaviors such as hoarding that drive up demand—and, therefore, inflation. Higher expectations can also put upward pressure on wage growth as workers increasingly demand to be compensated for the costs they expect to rise in the future.

Inflation expectations in Europe have been relatively high, likely reflecting the extreme price swings of petrol and food that consumers faced after Russia’s invasion of Ukraine. In Italy, inflation expectations after 24 months were 4.8% in Q2 2022, while they hadn’t been more than 2% since 2012.¹⁵ In Germany, consumers expect inflation to average 5.4% for the next five years. Even though German bond markets¹⁶ adjusted their implied inflation rate over five years down to 2.9% in June from 3.5% in April, it is still well above the sub-2% implied inflation that was consistent before the pandemic.¹⁷ To prevent these elevated expectations from causing higher actual inflation, the European Central Bank has eliminated its negative interest rate policy and is expected to tighten further.

Even in Japan, where overall inflation has been much weaker, expectations for inflation are up considerably from where they had been previously. The Tankan survey of businesses puts inflation at 2% over the next three years, a record high going back at least to 2014.¹⁸ One consumer survey shows that nearly 60% of consumers expect inflation to be more than 5% over the next year—a significant jump from where inflation currently stands.¹⁹ This is particularly surprising given that consumer expectations of inflation are often based on what consumers have experienced recently—currently, inflation is far lower than 5%. The Bank of Japan has yet to tighten its policy, but higher rates may be inevitable should more inflationary pressures mount.

In the United States, the United Kingdom, and Canada, inflation expectations look slightly better anchored. US bond market–based measures of longer-term inflation expectations are now in line with prepandemic norms after having come down recently due to fears of recession.²⁰ US consumer expectations for inflation over the next five years were at 2.8% in June, while they were typically around 2.5% prior to the pandemic.²¹ In the United Kingdom, bond-market inflation expectations for the next five years were 3.8% in June, down from 4.7% in March but still slightly above the 3.4% recorded in September 2019.²² Even consumer-based inflation expectations for five years were just 3.5% in Q2 2022, about where they were when the pandemic hit.²³ In Canada, consumer expectations for inflation over the next five years were at 4%, slightly lower than the peak reached back in 2018.²⁴

Expectations can change quickly in either direction. Although most inflation expectations have come down somewhat recently, the risk of those expectations returning remains serious, especially in economies such as Europe, where inflation may persist regardless of what is happening in the domestic economy. This may cause central bankers to keep monetary policy relatively tight even as domestic demand deteriorates.

Watch for a wage-price spiral

Central bankers are also wary of a wage-price spiral, where prices push wages higher and vice versa. Despite tight labor markets throughout most of the developed world, wage growth generally remains below headline inflation. In Q1 2022, when headline inflation for the eurozone was 6.1% year over year, wages were up just 3.8%.²⁵ Even in Spain, where monthly earnings per worker were up 5.4% year over year in Q1, headline inflation was still 2.9 percentage points stronger.²⁶ In the United States, average hourly earnings were up 5.1% from a year earlier in June, well below the 9.1% reading for inflation.²⁷ In Japan, average monthly earnings, which include bonuses, were growing slightly over half the rate of inflation.²⁸ Even in the United Kingdom, where weekly earnings of the private sector were up a lofty 7.2% from a year earlier on a three-month moving average basis, wage growth trailed headline inflation, which was up 8.4% over the same period.²⁹

Although wage growth is running behind headline inflation growth, it is running ahead of core inflation in some cases (figure 3). In the United Kingdom, for example, core inflation was just 6.1% year over year, more than a full percentage point behind wage growth over the same period. In the euro area, core inflation was just 2.6% year over year in Q1, also more than a full percentage point lower than wage growth over the same period. In Canada, wage and core inflation growth in June were growing at the same rate. Even in Japan, western core inflation was up just 0.2%, firmly shy of the 1.1% wage growth. However, in the United States, wage growth was still running below core inflation in June when prices excluding food and energy were 5.9% higher year over year.

Because inflation has been so heavily concentrated in food and energy throughout Europe, and to some extent in Japan, a wage-price spiral may be more likely. Workers are faced with higher prices for necessities such as petrol and food and likely demand higher wages as a result. The problem in these economies is that other sectors are not seeing strong demand. After all, the positive demand shock in these economies has been relatively weak or nonexistent. As wages rise to compensate for higher costs of living, sectors outside of food and energy may be forced to raise their prices to compensate for their increased labor cost. Thus, a wage-price spiral is born. It is in the United States, where demand is stronger and inflation more widespread, that a wage-price spiral seems least likely. The fact that wage growth has not been stronger, and has even moderated in the United States, given the incredible tightness in the labor market remains a conundrum for economists.

Falling currencies raise prices

Although what happens domestically is critically important to predicting inflation, changes in global economic conditions also need to be taken into consideration. Most critically, what happens in the United States can have sizable effects on inflation elsewhere in the world. As the United States continues to raise interest rates at a more aggressive pace than most of its developed-economy peers, capital has flowed into dollar-denominated assets. This dynamic has strengthened the value of the US dollar and weakened the value of other major currencies, including the euro, pound, and yen.

The euro and pound have each lost between 14% and 15% of their value against the US dollar in the year to July, while the Japanese yen has lost 25% of its value against the dollar over the same period.³⁰ A weaker exchange rate raises the cost of imports denominated in foreign currency. The prices of globally traded commodities, which are often priced in US dollars, were already expensive. A stronger dollar makes those commodities even more costly.

Import prices shot up 29.1% year over year in April³¹ in the euro area and 46.2% in June in Japan.³² Much of the increase can be attributed to higher food and fuels costs. However, other goods are also more expensive. For example, in the euro area, the prices of imported consumer goods excluding food, beverages, and tobacco were up 7.9% year over year in April.³³ In Japan, textile import prices were up 13.2% year over year in June, highlighting the inflationary effects of a weak currency.³⁴

Moving forward, exchange-rate pressures may begin to ease. Concerns over recession in the United States are raising doubts that the Fed can hike rates as quickly as the market currently expects. A less hawkish Fed would give other central bankers some breathing room as their currencies stabilize or even strengthen against the dollar. On the other hand, should the Fed be able to avoid a recession while other countries fall into one, we could see additional strength in the dollar and therefore more imported inflationary pressure.

It’s clear that inflation is a challenge throughout most of the developed world. How inflation evolves from here will depend on central-bank policy, inflation expectations, wage growth, and exchange rates. The effect these factors will have on each economy will depend on the underlying cause of inflation. Monitoring these variables and putting them in the proper context will allow business leaders to better anticipate the inflationary environment moving forward and make necessary changes faster than competitors.