Then, when the economy reopened, we saw strong pent-up demand for services. Since the start of the pandemic, the volatility of durable goods consumption has been almost ten times higher than during the preceding two decades, and almost 30 times higher for services. This has led to inflation broadening into both industrial goods and services. Today, around threequarters of the items in the core inflation basket have inflation rates above 2%. The second shock has been Russia’s unjustifiable invasion of Ukraine. Even before the invasion, OPEC+ production cuts and capital constraints on US shale producers were restricting energy supply. This resulted in a spike in energy prices which was a major factor in our underestimation of inflation. [2] But the invasion has hugely aggravated the supply squeeze and sent energy prices to extraordinary levels, making it all the more challenging to forecast inflation. European gas and electricity prices are up 105% and 75%, respectively, since the months before the invasion[3], and around 650% and 450%, respectively, since the first half of 2021. This surge in energy prices has directly contributed around 30% to the headline inflation rate since the start of this year and, indirectly, has added to the broadening of price pressures across the economy. In fact, the models used by the national central banks indicate that the indirect effects of higher energy costs are currently contributing around one-third to core inflation. The persistence of inflation Collectively, these shocks have pushed inflation a long way from our target.
In our downside scenario, which captures – among other shocks – the impact of a complete cut-off of Russian gas, we project that the economy will contract next year before picking up in 2024. But inflation is expected to be higher at the end of the projection horizon than in the baseline scenario. [14] A third factor will be the actions of governments. Monetary policy will do whatever is needed to return inflation to our target. But a truly European approach where monetary and fiscal policy complement each other can improve the inflation outlook. In particular, how fiscal policies support firms and households through the difficult winter ahead will play an important role in inflation dynamics. Targeted, temporary and tailored measures are needed to protect the incomes of the most vulnerable, while also preventing a significant loss of capacity owing to production cuts and bankruptcies. But beyond that, it will make a difference whether fiscal policy focuses mainly on public consumption and transfers – which may add to inflationary pressures – or on public investment and debt sustainability. As many of the sources of inflation today are on the supply side, government policies that lift supply and redirect investment to where it is needed are necessary to support sustainable growth. The pace of rate increases The second consideration in responding to current inflation is the pace of rate increases.