Why is inflation so persistent?

Central banks around the world are puzzled as to why inflation can only be partially brought under control with sharp interest rate hikes. Experts believe there is no quick fix.

Things are colorful at Praia da Conceição, one of the beautiful beaches in the Portuguese seaside resort of Cascais: colorful umbrellas, children jumping into the water and sunbathers licking ice cream. It’s holiday time in Portugal, the weather is glorious and the popular holiday resort some 30 kilometers west of the capital Lisbon is buzzing with life.

But holidays by the sea, even in their own country, are increasingly becoming a luxury for many Portuguese. Here, too, high inflation has left its mark. Similar to Germany, it reached 8.1 percent last year and is currently at 5.4 percent. Because the Portuguese earn significantly less than the Germans, they are hit all the harder by the sharp rise in prices.

Inflation has long been above the target mark

The currency watchdogs of the European Central Bank (ECB) know this, too, and are holding their annual central bank conference just a few kilometers away again this year. Here they discuss and debate together with around 175 representatives from central banks, scientific institutions and international organizations.

Key questions are where the inflationary spurt is coming from, why it is so persistent and what is best done to counteract it. Everyone agrees that inflation has been well above the target of two percent for far too long. There is no consensus as to how best to solve the problem.

ECB President Christine Lagarde had already confirmed on Tuesday that there would be another interest rate hike in July – and indicated further rate hikes. After the ECB initially completely underestimated and misjudged the development of inflation, it now wants to show that it has achieved what it promised the 346 million people in the euro zone: price stability. In return, it is willing to accept a recession in the euro zone – an economic downturn that has already begun.

Monetary policy is not working as desired

The central bank world remains guesswork as to why inflation is so persistent everywhere. The rate hikes are taking effect, but not as much as desired. The surge in inflation was triggered by the consequences of the Corona crisis, in particular by increasing de-globalisation. When the division of labor in the world no longer worked, goods became scarce and expensive.

Then came price hikes from high energy prices and the war against Ukraine – external shocks that the ECB was unable to do much about. Eventually, inflation started to get really stubborn as companies passed on their higher costs through higher prices and topped it off to increase their profits. Airlines, for example, doubled their ticket prices even though kerosene was becoming cheaper again. Tour operators and hotels grabbed a lot without needing it, knowing full well that customers were ready to dig deep into their pockets after Corona.

excessive corporate profits

And the food trade also saw an opportunity, reduced the contents of the packaging and increased the prices. According to calculations by the ECB, excessive corporate profits accounted for around two-thirds of the surge in inflation in the euro zone in recent months. In normal times it’s only a third. Another factor is now responsible for the persistent inflation: the high collective bargaining agreements in many countries and the resulting rise in wages.

According to the ECB, there are still no so-called “second-round effects” in which constantly rising costs lead to a spiral of rising wages. But that could also change quickly. Because the labor market is very robust everywhere due to the shortage of skilled workers. Trade unions can therefore push through high wage agreements. It remains to be seen how much of these costs companies will pass on to customers.

The fact is that all the statements and papers at the Sintra conference show that there is no quick fix for inflation. Because the problem is complex: For example, the chief economist of the European Commission, Miguel Gil Tertre, underlined the influence of climate change and unpredictable weather phenomena on energy prices: Heat drives air conditioning systems and refrigerators, heavy rain and storms lead to more destruction, floods cause protective measures – everything Costs that also fuel inflation.

Warning supply shocks at energy

Norway’s central bank president Ida Wolden Bache, representative of the country, which is currently the most important energy supplier in Europe, warned of new supply shocks in the energy sector. Not only because of the conversion to “green” energy, but simply because fossil fuels are finite.

And the first deputy managing director of the International Monetary Fund (IMF), Gita Gopinath, emphasized that these and other structural changes in the economy are leading to inflation that will remain much more persistent than in the times before the pandemic. So there are many reasons that speak in favor of further action by the central banks. Like most of the participants in Sintra, Gopinath called on the ECB not to let up in the fight against inflation, even if this is leaving its mark on the economy: “Inflation may be elusive, but it is not unknown,” said Gopinath. The ECB, like other central banks, would know exactly how to get a grip on them.

She didn’t have to say that twice to the hostess in Sintra and former head of the IMF, Christine Lagarde. The inflation target of two percent has top priority, said the ECB President. In the current situation of high inflation and how to combat it, one should not become fickle. Because: “We can’t announce a victory yet.”