Economics Update March 2023 - Why inflation is a stubborn foe

The latest inflation data have caused disappointment in many quarters, but are by no means surprising. The enormous expansion of the money supply due to the central banks' long-lasting expansionary monetary policy prepared the ground for disturbances in the balance between supply and demand to have a price-driving effect. The first inflationary effect set in when, in the Corona crisis, demand, which had been only slightly curbed thanks to generous government aid, was met by supply, which was significantly limited due to the pandemic. Then the rise in energy prices as a result of the geopolitical conflict between Russia and the West catapulted prices even higher. The result was an inflation rate the likes of which Germany had not seen in decades.

The 1990s: it took several years to bring inflation down

A comparison with the 1990s is helpful: At that time, rising inflation was triggered by the demand boom in the wake of German unification. The inflation rate rose from a moderate 2.4 percent in April 1991 to more than 6 percent within a year. The Bundesbank reacted very quickly at the time with significant interest rate hikes, triggering a recession. The Bundesbank's fight against inflation was made more difficult by a price-driving increase in the value-added tax at the beginning of 1993. But even after this special effect expired, it still took a full year for the inflation rate to fall below the 2 percent mark again for the first time in January 1995. It thus took almost three years from the peak of inflation to the inflation target being reached again.

Inflation proves stubborn

A look at the details of the inflation statistics shows how difficult it is to bring price development back to a normal level: Although overall inflation in Germany fell by more than two percentage points between October 2022 and February 2023, core inflation, i.e. the value of inflation adjusted for energy and food, still rose slightly at the same time. The contribution made by food alone to the inflation rate rose slightly from 2.6 to 2.9 percent over the same period. According to the Ifo Institute, half of retailers still intend to raise prices further in the next three months. That is 30 percentage points less than in mid-2022, but more than at any time in the past up to the start of the current inflation wave. In the industrial and service sectors, the finding is the same in a slightly weaker form, with only the construction sector showing fewer suppliers intending to raise prices further.

Significant risk of further monetary tightening

The government measures to cushion increased energy prices may be justifiable in social policy terms, but they make it considerably more difficult to combat inflation, especially across the board, because they protect disposable income for consumption and maintain a level of aggregate demand that cannot easily be reconciled with a normalization of inflation. Rising wages and salaries, which at least partially compensate for the increased cost of living, are certainly justified, but they have the same effect in terms of inflation development.

Reducing inflation to a level of around 2 percent is therefore a goal that can realistically only be achieved in the longer term and requires both monetary and fiscal policy discipline in the meantime. Interest rate cuts by central banks in the foreseeable future are therefore wishful thinking. Instead, market participants should look more seriously than before at the opposite scenario: The central banks could continue their cycle of interest rate hikes for a while longer in order to achieve the desired target, and in the process also accept a noticeably worse economy.