New inflationary headache on its way

Inflation is coming down quite quickly and the European Central Bank (ECB) has certainly been busy raising interest rates no fewer than 10 times in the past 14 months in order to quell inflation. In fact, never before has the ECB raised rates so many times in a row – the previous record was nine times back in 2006-2008.

But this comes on the back of a central bank that was very reluctant to raise rates in the first place, see Figure 1. Inflation in the Euro Area went above the bank’s medium-term target of 2% year-on-year in July 2021 but the bank maintained ultra-low interest rates for a whole year before starting its rates rises – at a time when, in July 2022, inflation had reached 8.9% in the Eurozone and 21.3% here in Latvia, see again Figure 1.

Back in 2021 there was among many a widespread belief that an uptick in inflation was a transitory phenomenon due to the opening up of the economies after Covid-19. As demand returned, supply just couldn’t keep up right away, leading to higher inflation, but this would dissipate fast, as supply chains would be restored. That was the “Team Transitory” story – the other side, dubbed “Team Permanent”, obviously, argued that inflation would be not permanent, but certainly persistent as it was a result of too much fiscal and monetary stimulus following Covid-19. Too much demand chasing too little potential supply.

Given the actions of the ECB – keeping rates low for July 2021 – July 2022 despite inflation rising and then very aggressive rate rises, I will allow myself to conclude that the bank changed its mind from “Team Transitory” to “Team Permanent”.

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Inflation is coming down quite quickly and the European Central Bank (ECB) has certainly been busy raising interest rates no fewer than 10 times in the past 14 months in order to quell inflation. In fact, never before has the ECB raised rates so many times in a row – the previous record was nine times back in 2006-2008.

But this comes on the back of a central bank that was very reluctant to raise rates in the first place, see Figure 1. Inflation in the Euro Area went above the bank’s medium-term target of 2% year-on-year in July 2021 but the bank maintained ultra-low interest rates for a whole year before starting its rates rises – at a time when, in July 2022, inflation had reached 8.9% in the Eurozone and 21.3% here in Latvia, see again Figure 1.

Back in 2021 there was among many a widespread belief that an uptick in inflation was a transitory phenomenon due to the opening up of the economies after Covid-19. As demand returned, supply just couldn’t keep up right away, leading to higher inflation, but this would dissipate fast, as supply chains would be restored. That was the “Team Transitory” story – the other side, dubbed “Team Permanent”, obviously, argued that inflation would be not permanent, but certainly persistent as it was a result of too much fiscal and monetary stimulus following Covid-19. Too much demand chasing too little potential supply.

Given the actions of the ECB – keeping rates low for July 2021 – July 2022 despite inflation rising and then very aggressive rate rises, I will allow myself to conclude that the bank changed its mind from “Team Transitory” to “Team Permanent”.

With inflation coming down, will we soon be around the 2% level again?

I can be a little concerned here for Latvia and a new “transitory” versus “permanent” debate may surface.

Figure 1: Inflation rates in the Euro Area and in Latvia, year-on-year, monthly data, 2018-I – 2023-VIII

Source: Eurostat

For more than a year real wages in Latvia dropped for the average person with inflation being higher than the growth of wages. Our purchasing power was diminished and during 2022 visits to supermarkets were less pleasant than usual while electricity and heating bills… Well, let us not even go there.

High inflation could be compensated for via higher wages and as we know, the labour market in Latvia is tight.

May employees succeed in obtaining higher wages? Data says… perhaps (see Figure 2). I show data from 2015 – way back in time but still significantly after the financial crisis where the labour market had somehow normalized. Wage growth hasn’t been constant over that period but for most of the time it has been in the 6-8% interval – with two periods standing out: 2021 (post-corona?) and 2023. During this year annual wage growth has jumped to 12% and the question therefore is: is this just a blip (transitory) or is this a permanent feature due to compensation for high inflation?

If the latter is the answer Latvian firms shall once again have to worry about Latvia’s competitiveness – and we all will have worry about some more future inflation as such higher wage costs will be reflected in higher prices of goods and services.

But we have to wait for data from the coming quarters before a conclusion can be made.

Figure 2: Wage growth in Latvia, year-on-year, quarterly data, 2015-Q1 – 2023-Q2

 

Source: Official Statistics Portal of Latvia

In short, interesting times ahead. As always…

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga.

 

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