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Theme: Will inflation persist?

New inflation risks in Europe due to high energy prices

Indirect effects of high energy prices will lead to a broader and more protracted inflation upturn in Europe. A long period of rising prices for energy and other commodities before the global financial crisis led to several years of CPI inflation above central bank targets but had only a minor impact on prices of other goods and services. Energy prices are rising this time in a situation where supply side disruptions have already created underlying inflationary pressure, which suggests that their effects on core inflation will be greater this time around and upside risks will increase if prices do not fall back according to market expectations. Electricity and natural gas prices have risen most in the euro area, whereas corresponding prices in the US have increased relatively little.

The inflation rate in most European countries has climbed steeply in the past 3-6 months, reaching levels not recorded since the early 1990s. This upturn is largely explained by sharply rising energy prices with electricity and natural gas prices recently surging at unprecedented speed. Energy prices appear to have culminated just before Christmas, but there is much uncertainty. Electricity and natural gas prices will probably remain at historically high levels during the next two years. There are risks that via indirect channels, energy prices will help to push up inflation further. Over the past 30 years, earlier large upturns in commodity and energy prices have only led to minor increases in core inflation, but the recent round of such upturns occurred in a situation where earlier commodity price increases had caused producer prices to climb at their fastest pace since the 1970s. Because of production and transport disruptions, the impact on end consumers risks exceeding historical levels. Sweden’s upturn in electricity prices now appears likely to be smaller and more short-lived than in the euro area and United Kingdom, but due to large imports from Europe especially consumer goods higher prices in these countries may also have consequences in Sweden.

A historically unparalleled energy price shock

Prices of electricity and natural gas in Europe soared during the second half of 2021. Several factors contributed to this increase (see theme article, page 22). Although both we and the market believe that these prices will fall back, over the next two years they are expected to remain much higher than before the pandemic. The upturns are largest in the euro area and the UK, while the price trend in Sweden is less dramatic. Electricity prices in Sweden (where natural gas is not used) will also fall faster, according to the futures market, and will be almost completely normal by 2023. The situation is generally more serious elsewhere in Europe because actual electricity and gas price increases have been stronger than in the US and because the region, like the US, depends on gas for heating. The combined effect makes the supply shortages especially noticeable. Energy futures indicate that European prices will also normalise, but not until during the period 2024-2026.

Major differences between countries

Because of overall prices upturns for electricity and gas, as well as for oil and petrol, late in 2021 energy prices contributed 2-3 percentage points to inflation in both the US and Europe. In the US, the upturn is mainly explained by higher oil prices, which have a much greater effect on CPI there than in Europe. Although energy prices have risen significantly more in the euro area and the UK, their contribution to inflation has been higher in Sweden. One reason is that their impact on CPI is slower in most euro area countries especially Germany and in the UK. In addition, many countries have cut energy taxes or introduced subsidies to mitigate rising prices. Some form of household subsidy is also on its way in Sweden, but it is still uncertain how it will be designed. The difference in impact on CPI between European countries is remarkably big. In the Netherlands, for example, the electricity and gas component in HICP has risen by more than 40 per cent since August. The corresponding increase in Germany so far is only a few per cent.

Because of the slower impact in the euro area and the UK, prices will not fall to the same extent in 2022, and when supportive measures are removed this will have a similar effect. As a result, energy prices will continue to push up inflation during 2022 and only provide small negative contributions to inflation during 2023.

Rising energy prices not only affect households but also the corporate sector. One metric for the strength of the cost increases is producer price indices (PPIs), which have risen by more than 20 per cent. This is largely explained by the fact that energy prices in the euro area, for example, have climbed by a full 70 per cent. We have to go back to the oil price shocks of the 1970s to find increases in the vicinity of these levels.

Powerful and protracted upturns before the global financial crisis

The last time we saw a rapid rise in producer price indices (PPIs) was before the outbreak of the global financial crisis. Although the annual rate did not reach more than 10 per cent at that time, the increase was protracted. Viewed over the entire period 2004-2008, the accumulated upturn was larger than the current one, at least compared to price levels before the COVID-19 pandemic. The price upturn before the financial crisis had some similarities with the current upturn, but it was driven to a large extent by oil prices reaching record levels. Gas and electricity prices, on the other hand, rose very little at least in Europe. The PPI upturn for commodities, as now, was relatively broad including sharply rising food prices. Despite a slight fall in energy prices at the beginning of 2022, PPIs are expected to continue upward in the coming months, driven by rising prices for processed goods. The upturn for consumer goods especially when they reach final consumers and become part of the CPI are of course more moderate, since they include more value-added steps where margins dilute the effect.

Limited impact on consumer goods – so far

Energy and commodity price increases during the years before the financial crisis did not lead to any broad upturn for either producer prices or the CPI, although goods prices accelerated somewhat. So far, we have only seen moderate increases in PPIs and CPI for consumer goods in the euro area and Sweden. In the UK and to an even greater extent in the US, goods inflation according to both PPIs and the CPI has climbed to nearly 10 per cent. We believe price increases in the US are currently being driven more by a nearly 20 per cent increase in demand for goods during a short period than by costs of input goods. However, production and transport problems, both domestic and international, suggest that the ability of businesses to pass on increased costs to consumers in Europe is also greater than before the global financial crisis, when sharply increased production in China pushed down international prices of industrial and consumer goods. Today there is less room than usual for businesses to absorb rising costs. The energy price upturn in Europe started in the middle of 2021 and the big rise did not come until the fourth quarter. It is likely that indirect effects on prices will appear after a lag and that PPIs and CPI will accelerate in 2022

Due to rising oil prices, and to a lesser extent food prices, CPI inflation in the US was continuously above 2 per cent in 2004-08. On average, CPI increased by 3.2 per cent during that period. In the euro area, too, CPI was above 2 per cent for much of the period, averaging 2.3-2.4 per cent. Swedish inflation stood out on the downside; CPIF (CPI less interest rate changes) was only above the Riksbank’s 2 per cent target in late 2007 and in 2008; average inflation in 2004-08 was only 1.6 per cent.

Bigger indirect effects than in 2004-2008

Mechanical calculations indicate that indirect cost increases for households should be about as large as direct effects of higher energy prices. But over the past 30 years, the actual indirect effect has been far less, usually because the energy price upturn has been brief and could be absorbed by producers, thus reaching final consumers only to a very minor extent. Both indicators and the actual trend of various inflation metrics nevertheless suggest that indirect effects may be larger now than they were in the mid-2000s. Core inflation excluding energy is expected to rise by more than 2.5 per cent during 2022, the highest for at least 20 years. As for the euro area, we should also take into account that abnormally high prices early in 2021 will help lower year-on-year price increases for a few months in early 2022. In the UK, where Brexit has contributed to major shortages of both goods and labour, core inflation will climb to 4.5 per cent. The risks of even larger, more persistent upturns will increase unless energy prices fall back in keeping with market expectations.

But to actually make inflation remain at high levels for a long time, an eventual acceleration in pay increases is required. At present there are no signs of this in Sweden or the euro area. Given our assessment that energy prices will fall in keeping with market pricing, CPI inflation is about to culminate. This will reduce the risk of rising inflation expectations and compensation claims from employees.

Nordic Outlook February 2022