Weekly Update - Inflation driven by wages or profits? Different symptoms but the same response

The surge in inflation has raised fears of a 1970s-80s style wage-price spiral. It now seems inflation is being spread through Euro area economies more by profits than price pressures. Either way, bringing down price pressures will mean easing the pull of demand on the limited available supply. The ECB will continue to meet this challenge by tightening monetary policy. 

From external to internal inflation. Euro area inflation was initially triggered by a succession of external shocks (Covid, Ukraine war) which drove up import prices (goods, energy, agri-products). Coming on top of a strong post-Covid recovery, these shocks took rapid hold on booming demand and spread gradually through all goods and services prices in the area. In this way inflation became internalised to the region's economies, prompting the European Central Bank to tighten its monetary policy with the prime aim of repressing demand.

Second round effects work mainly through margins. Now that inflation has spread through the economy, the fear is that it could embed itself for the long term. Inflation is a negative cost, which different types of economic agents try to offset. Their offsetting strategies can have consequences for second round effects and embed the rise in inflation more durably. Workers try to minimise the costs of inflation through their wage demands, making good through higher salaries what they have lost through higher prices, so generating the risk of a wage-price spiral. Meanwhile, companies also try to minimise their share of the pain by hiking their prices to protect margins, again generating the risk of a wage-price spiral. Today, unlike the 1970s and 1980s, barely any salaries are index-linked to inflation, and it is obvious that wage rises across the Euro area are well contained. Company profits however are growing apace, helping explain the stubbornly high inflation we are seeing, and posing a real risk that strong inflation could embed itself for the long term. 

Need to depress demand relative to supply, which means monetary tightening whatever the cause. Inflation thus continues to propagate through the Euro area. This represents a cost for economies, with inflation sharply eroding household buying power. This is very unlike the 1970s and 80s when it was companies that bore the brunt of inflationary effects. The symptoms are therefore different. But, while the propagation mechanism may differ, the key short-term response remains the same: to dampen demand so companies find it harder to pass on inflation in their selling prices. The European Central Bank thus has every reason to continue tightening monetary policy through further interest rate hikes. These rises will slow demand by making borrowing more expensive and channelling money into higher-paying savings. Medium term, if the price-profits spiral persists, the authorities are likely to raise taxes on profits or tighten competition rules.

Finally, in the main events of the week, we have chosen to talk about the US and Euro area GDP figures and to focus on corporate earnings.

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