Why is inflation so high and so different in different euro area countries?

Madis Müller, Governor of the Bank of Estonia in his speech looks at this question of why inflation is so high and diffeernt in Euroarea economies:

The search for the causes of the current high inflation starts in the aftermath of the Covid-19 pandemic. The global economy recovered fast once the pandemic ended and the restrictions on consumption and travel were lifted. Aggregate demand in our economies bounced back, and it was also boosted by the wide-ranging support measures that governments and central banks offered to help companies and households cope with the crisis. It turned out that not all companies could respond quickly enough to this increase in demand, as some restrictions lingered and supply chains remained fractured. This put pressure on input prices that was then passed on to consumers.

Then Russia attacked Ukraine, and this caused energy and commodity prices, including food prices, to increase sharply. The energy crisis hit Europe especially hard as the European Union as a whole and many member states were heavily dependent on Russian oil and gas. Russia weaponising energy pushed inflation up to levels not seen since the last great oil shock in the 1970s and 80s. By October last year inflation in the euro area had passed 10%, though inflation rates were very different across the member states, ranging from 7% in France to above 20% in the Baltics in that month. Inflation in Slovenia was just below the euro area average at 10.3%.

The differences between the inflation rates in the various countries of the euro area first started to widen in 2020 when the pandemic caused stronger disinflation in countries that have large tourism sectors. As the pandemic faded, inflation picked up most in countries where the economy had declined less and where labour shortages were starting to put pressure on wages. The Baltics were hit even harder by supply chain disruptions when the war and sanctions cut off imports from Russia and prices rose. Before the war started, gas and electricity were relatively cheaper in the Baltic countries than they were on average in the euro area. This relatively low starting point made the subsequent price increases larger in percentage terms.

Reasons:

Let me summarise the main reasons why inflation was particularly high in Estonia, reaching close to 20% last year. Much of the following also applies to Latvia and Lithuania as the other two Baltic countries.

To start with, the share of energy and food in the consumer basket is still somewhat higher in our countries than the average in the euro area. This meant that rapid rises in the prices of energy and food in particular consequently had a bigger impact on our inflation readings.

Compounding this, price setting has traditionally been more flexible in the Baltic region than in other euro area countries, meaning that both rises and falls in commodity prices are translated more swiftly to consumer prices. Administered prices are also flexible and governments have allowed higher global energy prices to pass through quickly to regulated prices, while governments in some other euro area countries have been more cautious.

A third and more general reason why inflation has been high in the Baltic countries was that the economic impact of the pandemic was more limited in our region and the pandemic was followed by a very strong and swift recovery. Expansionary fiscal and monetary policies combined with strong domestic demand pressures therefore contributed to an increase in inflation.

What this means for monetary union?

The substantial dispersion of inflation rates between the countries of the euro area poses the question of how harmful these differences are in a monetary union. Obviously there will always be differences between the structures of our economies, and so there will always be some differences between the inflation rates in different countries. Such differences have been around since the euro was first introduced, though for most of the time they have been minor.

Large differences in inflation rates could however lead to problems with the smooth functioning of a common currency area. An obvious problem is that a common monetary policy allowing nominal interest rates to be similar in all of the euro area countries will lead to differences in real interest rates if there are differences in inflation. The real interest rates in countries with higher inflation might be too low, while the real rates may be too high for countries with lower inflation.

The common monetary policy then becomes too lax for some countries and too tight for others. There may also be possible concerns about the price competitiveness of individual countries in a monetary union if they experience persistently higher inflation at the country level. Finally, not every country in a monetary union will have identical economic and financial cycles, and this can then in turn cause differences between national inflation rates. These are well-known challenges faced by monetary unions and the solution can only lie in the prudent use of other economic policies by the government – that is their structural and fiscal policies.

Challenges for the European Monetary Union continue from all corners..

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