Economic Research: Eurozone inflation should fall

Eurozone reports record inflation, but levels should match ECB targets by the end of 2023.

Eurozone inflation is running at record levels. In the Netherlands in June, it was over 11%. In other countries, especially the Baltic states, it is even higher. For the Eurozone as a whole, it is currently averaging around 9%, significantly higher than the European Central Bank (ECB) target of 2%. Inflation is, unquestionably, a hot topic being discussed in boardrooms and among economists throughout the world. Among businesses in the Eurozone, questions are now being asked about whether inflation expectations will detach from the official ECB target, or whether levels will begin to cool and, if so, when.

These are the issues that myself and my Atradius colleagues, Senior Economist Theo Smid and Economist Dana Bodnar, explored in our most recent Economic Research. Our calculations revealed fascinating results. The primary headline is that despite worryingly high levels of inflation across the Eurozone, this is now peaking and should slowly begin to decline so that it reaches the ECB target of 2% by the end of 2023.

ECB acts by hiking policy rate

The ECB takes decisions on monetary policies every six weeks. In July, at its most recent meeting, the ECB increased the policy rate by 50 basis points in an attempt to contain and reduce inflation. This marks an end to the wait-and-see policy that the Bank had been following up until now. The ECB has also stated that it will continue to monitor inflation levels, but we believe that one or even two additional hikes are likely in the remainder of this year. That said, the ECB intervention has been relatively modest, which could also reflect expectations that inflation will subside. 

How do energy prices influence inflation?

Energy prices have played a major role in the high levels of inflation we have witnessed in the Eurozone over the past few months. When we conducted a year-on-year comparison, the energy component of the total price index increased by as much as 42% in June. In fact, nearly half of June’s Harmonised Index of Consumer Prices (HICP), which is based on data gathered by the national statistical institute of each of the Eurozone countries, can be attributed to higher energy prices.

 A major underlying reason for energy price rises lies with the war in Ukraine and, in particular, with the ensuing sanctions which have pushed energy prices to record levels. However, we do not believe these will be sustained or grow much higher. This is because further price rises would need a further shock such as a complete boycott of Russian gas supplies or for Russia itself to end supply to the West. We think this is unlikely. Although the EU has most recently aligned with the G7’s oil boycott, this will not take effect for another six months. What’s more, it is unlikely that Russia will want to end oil or gas sources of income, especially while seeking to fund a war.

Why will inflation decline?

Our core argument is that a recurrence of the energy price rise is unlikely. However, it is also important to remember that the underlying factors that have kept a lid on inflation over recent years have not gone away. Although many were impacted by the pandemic, much of this was temporary. Globalisation, digitalisation, weak wage growth and ageing populations are ongoing factors that will continue to put a brake on inflation. Likewise, the role of the ECB will continue to be an important factor moving forward.

 What’s more a key trigger for the rise in inflation by the initial recovery of economic activity following the pandemic recession combined with supply chain issues. As these pressures now subside, this source of inflation will lose its strength. If wage levels can also be kept under control, and that is what we are seeing at the moment, this can help avoid any spiral of price and wage rises.

What insight can the Atradius economists share?

We outline our calculations and conclusions in more detail in our report: Atradius Economic Research August 2022: Inflation expectations not yet decoupled from the official ECB target. This includes our simple, but powerful conclusion based on our mathematical findings that the current levels of high inflation are not here to stay. We calculate that the inflationary spike of 2022 will be matched by a mirror image drop by the end of 2023.

Download the Atradius Economic Outlook here