Europe is facing structurally higher inflation

A few days ago, the Eurozone inflation data for January was published along with the inflation outlook for 2022 onwards contained in the EC document. While the figures come as no surprise, they do force us to shape our narrative on prices in the post-pandemic economy. Inflation remains transitory yet persistent, and this persistence could lead to permanence—in other words, it could have structural effects.

The idea is that this inflation, which originates from a transitory shock in energy and transport costs, by taking its time to be diluted and spread to the rest of the basket, is persistently changing relative prices and exerting pressure on nominal revisions of salaries and pre-established prices (such as rents).

These and other factors suggest that we will face structurally higher inflation after the current upturn (which will probably be prolonged, maintaining its base effect until 2023). The reason lies in the changes that, beyond the current circumstances, are becoming entrenched in this new phase of recovery. They are the usual suspects. Energy prices seem likely to climb persistently over time, whether through the green transition and the internalization of production externalities, or the search (always deficient at the outset) for new energy sources, which will be expensive, at least in the short term. This is especially worrisome in Europe, which is heavily dependent on both energy and raw materials and where that green alternative (lithium, rhodium, rare earths...) is restricted by geopolitics at all its cardinal points. At the same time, the region is held captive by commitments that are sometimes hard to justify (nuclear in Germany).

We also have the supply chain problems. Both sides of the Atlantic are working to disengage from China. Although the US side has lost some momentum (Build Back Better), the underlying philosophy remains alive and could be revived due to renewed trade tensions. Similarly, Europe is aware that China is a strategic challenge and is therefore trying to reduce its dependency, especially in terms of semiconductors. Its target is 25% of global production versus the current 10%, but for now, this will be transferred to sunk costs that will be reflected in inflation in the long term.

The prolonged presence of higher inflation is already impacting other goods and services. The longer this phase lasts, with certain goods and services being re-priced, the deeper the second-round effects will be, impacting present value at the same pace.  Let’s hope that the link between long and short-term effects remains strong, and we manage to delay the future effects, so they do not impact the present. They are certainly not what we need during this change of cycle.