Inflation surge in Germany: one swallow does not make summer

Inflation surge in Germany: one swallow does not make summer

At the end of 2019, core inflation in the euro area rebounded. Higher German services inflation was a major cause. And not surprisingly, the tight labour market had previously fuelled wage increases, especially in German services. As wages can be a major driver of inflation, for a while inflation seemed to be on the path to the ECB's 2% target. However, one swallow did not make summer yet. At the beginning of 2020, inflation fell. Nevertheless, inflation is picking up in a number of service sectors. This illustrates that the economic link between low unemployment, higher wage increases, and more inflation has not disappeared. But it works slowly. Creating more inflation in the eurozone remains a long-term task.

Inflation surge was a false signal

Between July and November 2019, service inflation in Germany rebounded from 0.5% to 2.4% yoy. Core inflation reached 1.8%. The rebound in Germany accelerated core inflation in the euro area to 1.3% by the end of 2019. It looked as if inflation in the euro area would finally get away from the too low level of 1%, around which it had been fluctuating since 2017. Was inflation on a path to a ‘lower than but close to 2%’ rate? That is the level the European Central Bank (ECB) has been aiming for. It has been using an arsenal of exceptional policy instruments for this purpose for some time now, such as a negative policy rate since mid-2014, but without much success. Did the increase in inflation mean the long-awaited normalisation of ECB policy was shining on the horizon?
Germany holds the key to higher inflation in the eurozone. The fact that the acceleration in inflation came from Germany could justify hopes of a return to more normal interest rates. At least, if that inflation acceleration were sustainable. The recent economic developments in Germany suggested that this could have been the case. The boom in 2017 had pushed the tightness of the labour market to its limits. As might be expected, this also fuelled the pace of wage growth. Wage growth accelerated especially in the service sectors (Figure 1). In industry, it was nipped in the bud from mid-2018 onwards by the fall in production. However, the economy remained much stronger in the service sectors. As wages generally account for a larger share of costs in these sectors, one might reasonably assume that this was the main driver of the acceleration in service inflation.

Yet the rise in inflation turned out to be unsustainable. In January 2020 inflation dropped to 1.4% yoy. In the euro area, core inflation fell to 1.1%, returning to the low levels of recent years. The upsurge in inflation at the end of 2019 turned out to be a false signal. On closer inspection, it was rather the result of volatility, caused by a change in the processing of package holiday prices in the consumer price index in Germany.

A work of long endurance

Does this mean that inflationary pressures are not increasing at all in the eurozone? That would be odd, because wage pressure has also increased in other euro zone countries in recent years. A detailed analysis of service inflation shows signs of accelerating inflation in the last two years, but only in some subsectors (Figure 2). This is particularly noticeable in services where labour costs can be assumed to be by far the most important cost factor. These include all kinds of maintenance and repair services, care, leisure and culture. Together they account for about 10% of the consumer price index. For other services, a trend increase in inflation is less obvious. This is often due to high volatility. In some service sectors, the greater importance of infrastructure or other costs can also temper the direct inclusion of rising wage costs in consumer prices.

The low weight of these services in the consumer price index is one of the reasons why core inflation in the euro area remains so low. Other factors also play a role. Higher wages do not necessarily lead to higher inflation. If they are accompanied by productivity gains, unit labour costs do not rise and are not a direct reason for entrepreneurs to raise prices. However, the recent acceleration of wage growth in the euro area has been accompanied by a slowdown in productivity growth. This is a normal cyclical phenomenon when economic growth cools down. As a result, unit labour costs have risen even faster than wages. In Germany in particular, however, companies have absorbed this increase in costs in their profit margins. Measured in terms of the share of their operating result in their added value, they are now at an all-time low. This cannot be sustained indefinitely. It suggests that entrepreneurs will try to restore their margins in the next economic upturn. This will contribute to higher inflation once again.
But it is clear that creating more inflation in the eurozone remains a long-term task. If the economic climate improves, productivity growth will also recover, which will dampen cost pressures and also lead to higher profit margins. This will limit inflationary pressures. Meanwhile, the corona epidemic is exacerbating uncertainty. Together with the weakness in industry, this could reduce wage increases in the forthcoming negotiations. Also, the international environment remains weakly inflationary, so no inflation will be introduced. The inflation surge at the end of 2019 may have been a swallow, but it did not yet bring summer!