Inflation reached 21.5% in August 2022 and increased to 22.4% according to Eurostat in September, its highest level since 1996. We typically think of this as the effect of soaring energy prices and the way they have filtered into transportation costs and from there to food prices etc.
I will argue that there is somewhat more to the picture. Below I have six possible reasons for inflation and I will argue that the first five are/have been present in Latvia and that we have to hope that the sixth will not materialize to cause even higher inflation. Let me deal with them one at a time, mostly with graphs and with just a little bit of text.
Reason #1: Demand pull factors
Higher inflation did not just materialize after Russia started its war in Ukraine. Looking at Figure 1, I think of August 2021 as the first month where inflation starting taking off. In that month, inflation hit 3.0% in the Euro Area, well above the ECB monetary policy target of 2%, and 3.6% in Latvia. Our economies had finally come out of corona with rising demand being the result – for travel, for restaurant visits, for hotel accommodation and more. Result: Rising prices, rising inflation.
I could perhaps here have added excessive corona support due to the pandemic – many governments, notably USA, pursued an overly expansionary fiscal policy during the pandemic, thereby adding to inflation.
Figure 1: Monthly inflation rates (year-on-year percentage changes), Euro Area and Latvia, 2019-I – 2022-IX
Reason #2: Cost push factors
As e.g. travel resumed and work from home declined, demand for fuel rose, with higher prices as a result. This was also before Russia’s invasion, see Figure 2. During Covid-19, oil prices were at rock bottom due to significantly lower demand (airlines weren’t flying…). Coming out of the pandemic demand – and prices – quickly rose, adding to costs for airlines, car owners, transportation companies with higher inflation as a result.
With the war and gas supplies from Russia mostly cut off, gas prices exploded and became a very significant cost push factor. As Figure 2 also shows, oil prices do not currently add to more inflation since they are down; recently it has been gas where Europe is so vulnerable.
Figure 2: Oil price, USD per barrel, past 5 years
Reason #3: Loose ECB monetary policy
Since 2014, the ECB had pursued an ultra-low interest rate monetary policy, see Figure 3. While inflation continued its rise from August 2021 (see again Figure 1), the ECB at first chose to continue this policy, hoping/thinking that higher inflation was just a temporary phenomenon. Well, it was not but monetary policy wasn’t tightened until July 2022, almost a year after inflation had taken off. To my mind, too late.
Figure 3: ECB interest rate (marginal lending facility), 1999 – 2022
Source: FRED database, St. Louis Fed
Reason #4: Imported inflation
USA’s central bank the Federal Reserve Board, tightened monetary policy much earlier and more aggressively than the ECB, sending US interest rates up, thus making US government bonds very attractive for investors. Result: Big capital inflow into the US to buy such bonds (and, as always in crises, as a safe haven) resulting in big demand for US dollars, driving up the price of dollars, aka the exchange rate, see Figure 4. The price of a dollar has risen no less than 26% since the beginning of 2021.
But since oil and many commodities are quoted in dollars, the Euro Area has imported inflation when buying such items. As an example, take nickel. Its price is up some 65% in dollars since the beginning of 2021, not just due to Russia’s war (Russia is a big producer of nickel) but very much due to post-corona higher demand. But the price will then be up an extra 26% in euro, adding even more to inflation in the Euro Area.
Figure 4: The USD-EUR exchange rate, 01.01.2021 – 03.10.2022
Reason #5: A tight labour market
The Latvian labour market is, as we know, very tight with a very low unemployment rate. This pushes up wages, also in excess of productivity gains. As can be seen from Figure 5, wages in the Latvian economy have risen about 8% per year on average – there is pretty much a horizontal trend line at 8% if one forgets about corona that distorted the labour market somehow. 8% in productivity gains per year certainly does not happen so some of the wage growth filters into prices and adds to inflation.
Figure 5: Wage growth in Latvia (monthly data; percentage change year-on-year), 2017-I – 2022-VI
Source: Official statistics portal of Latvia
Potential reason #6: Wage-price spiral
Data in Figure 5 is available until and including June 2022. Inflation has certainly been on the rise since then, reducing the purchasing power of our incomes. Will this deterioration of real wages lead to demands for higher wages, which, if successful, will add to costs for firms, leading them to pass those higher costs on to you and me in the form of higher prices, leading to yet higher inflation, which could make employees ask for even higher increases to their wages, leading firms… do continue this snowball effect if you so prefer.
The data is not there yet and the ECB’s recent interest hikes – of which there will be more – combined with an oncoming small recession may still quell this wage-price spiral before it takes off.
We shall see. But I think it is illuminating to see current high inflation as the result of many more factors than “just” higher energy prices.
Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and Vice-Chairman of the Fiscal Discipline Council of Latvia