Economics

Significant Price Increases in Germany

Why companies should keep a very close eye on inflation developments

Ralf Fendel - November 11, 2021

Inflation in Germany is currently higher than it has been in a long time. The causes are mainly rooted in the supply side of things. Energy and food prices are continuously reaching new highs due to disruptions at suppliers and distributors, partly triggered by the impact of the pandemic. The increase in prices has now become significant compared to 2020. Self-inflicted factors, such as the CO2 tax increase at the beginning of 2021, are also not to be ignored. Energy prices were unusually low in 2020, which also led to drastic price increases. Supply-side induced inflation generally influences prices only in the short-term. However, there are fears that the inflation rate will take on a life of its own and lead to permanently higher inflation. The ECB would respond to that decisively, the question is what factors companies should keep in mind to react right and in time.

- Expert opinion -

The inflation rate in Germany was 4.1 percent in September 2021. This is a remarkable development as a similarly high inflation rate was only observed back in 1993. While filling up with gas, going shopping, or paying their electricity bills, people clearly notice this in their wallets. But why are prices rising so sharply right now?  

What fuels the rise in consumer prices

There are many reasons for the current high inflation rate. On the one hand, there are so-called base effects due to low prices in 2020. In particular, the temporary reduction in value-added tax rates in the second half of 2020 and the drop in prices for mineral oil products in 2020 are (through their normalization on previous levels) once again having an increasing effect on overall inflation. In addition, there are crisis-related effects, such as significant price increases at the upstream production stages due to still disrupted supply chains in international trade, which have so far only been reflected in the consumer price index in part or to a lesser extent.

As was already indicated with respect to the base effect, it is above all the current rise in energy prices that is driving inflation. Heating oil (+76.5 percent) and fuels (+28.4 percent), for example, have become significantly more expensive than in 2020. Collectively, prices for energy products have risen by 14 percent. The underlying causes, in turn, are multifaceted. Above all, the upturn in the world economy and the associated global demand for energy caused prices on the international energy markets to rise. The CO2 tax introduced at the beginning of 2021 is also having an increasing effect on the inflation rate for energy products. In addition to energy prices, food prices increased at an above-average rate of +4.9 percent in September 2021 compared with September 2020. This was mainly due to adverse weather conditions in Spain and Italy, which led to a shortage in the supply of agricultural products such as vegetables.

Overall, it has shown that inflation is currently rising due to supply-side factors. Production costs and intermediate products - including prices energy and unprocessed food - are rising, making consumer products more expensive. Excluding the energy and food categories, the inflation rate would currently be at 2.9 percent, thus only moderately above the inflation target of the European Central Bank (ECB).

How inflation might develop

Supply shocks are generally of a short-term nature, so that many experts assume that the inflation rate will return to a lower level over the course of 2022 at the latest, once the temporary causes (crop failures, etc.) have disappeared and the current cost increases have fully translated into higher consumer prices. However, there are also risks that the initially only temporary cost shock will manifest itself in permanently higher inflation. Central to this are the inflation expectations of economic players. If the current high inflation rate leads to expectations of permanently higher inflation, this will lead to higher wage agreements, for example, which in turn run the risk of setting in motion a wage-price dynamic that will then lead to permanently higher inflation rates. If entrepreneurs expect permanently higher prices (and thus costs), they will react in advance by raising their prices in order to anticipate the cost increases. Thus, even just expected inflation translates into actual inflation.

This potential fact of inflation dynamics becoming self-contained explains the ECB's current communication strategy. The ECB strongly emphasizes that this is only a temporary inflation phenomenon to prevent an increase in inflation expectations as far as possible. To what extent this can succeed is a question of the ECB's credibility. In the case of supply shocks, monetary policy tends not to be particularly effective regarding the underlying causes, as it acts by managing the demand side of the economy. However, if there is a sustained increase in inflation, the ECB will react and, for instance, reduce its bond purchases ahead of schedule and consider raising interest rates. This would have adverse effects on employment and growth due to the associated dampening of demand.

What costs are resulting from fighting climate change

It should be emphasized that energy prices will continue to rise in the medium term (or structurally), irrespective of the current cyclical increase, as a result of the energy turnaround and the associated greater taxation of conventional energy sources. This is already being referred to as "green inflation". However, spending on energy accounts for only part of consumer spending, so its increase does not necessarily imply simultaneous, general higher inflation. If there are parallel reductions and disproportionately low increases in prices of other goods and services, the energy turnaround will not cause higher inflation rates. We should therefore not jeopardize the fight against climate change based on temporary inflation effects. The climate change damage will be far greater than that of the possible inflation effects. The latter would be moderate, if at all, and according to current estimates would not exceed one percentage point of additional inflation. The extent to which energy prices will decline again in the short term (cyclically) or even increase further is also a question of how cold the winter will be, as corresponding very strong increases in demand could drive prices. Adverse distributional effects of higher energy prices (whether cyclical or structural) could be cushioned by fiscal measures such as the (temporary) suspension of value-added tax on energy sources.

How is inflation measured?

Inflation is measured as the change in the consumer price index compared with the same month of the previous year. The consumer price index is based on a representative consumption basket consisting of a total of 650 goods and services with around 300,000 individual price observations. Individual goods are weighted according to their share in the expenditure of a typical household. The percentage change in spending on this consumption basket is taken as the measure of inflation.

Tips for practitioners
  • Be prepared for higher inflation rates which may last at least until the summer of 2022!
  • Keep an eye on wage reactions! They are an indicator of whether higher inflation rates will occur in the long term.
  • Pay attention to the ECB and its monetary policy! Indirect inflation dynamics also depend on confidence in the central bank. If inflation increases permanently, the ECB will react by exiting its current ultra-expansive monetary policy and taking countermeasures.
Author

Prof. Dr. Ralf Fendel

Professor Ralf Fendel is an expert on monetary policy and monetary theory at WHU - Otto Beisheim School of Management. His research is mainly empirical and deals with the effects of monetary policy on financial markets or the overall economy. In addition, his research focuses on issues related to the functioning of financial markets as well as on topics related to European integration.

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