Typically, when the source of an inflationary shock is stemming mainly from demand, monetary policy will respond proactively to prevent the economy from overheating. And when faced with supply shocks, to the extent that such shocks are seen to have no lasting impact on inflation, central banks will “look through” and extend the medium-term policy horizon if necessary. But such a neat categorisation does not adequately capture the situation we are facing in the euro area today. We are not seeing the type of demand-led overheating that is visible in the United States and, despite a tight labour market, the risk of a wage-price spiral so far seems to remain contained. Instead, the euro area is seeing an increase in inflation driven by two unprecedented shocks. These shocks have constrained global supply, but they have also shifted demand and led to a large and persistent inflation response. The first shock was the pandemic. Pandemic-related supply bottlenecks and rising prices have reinforced each other, with firms reacting to the threat of shortages by ordering more and earlier. This “bullwhip effect”[1] has driven up prices along the pricing chain. At the same time, the fiscal and monetary policy response to the pandemic has succeeded in protecting nominal incomes, thereby supporting a fast recovery of demand when our economies reopened. The resilience of incomes has, in turn, triggered large swings in demand across sectors. During the lockdown period, and thanks notably to e-commerce, consumption was concentrated on durable goods.
Headline inflation – which was negative as recently as December 2020 – has risen by 9.4 percentage points from its trough during the pandemic to its peak last month. Core inflation has risen by 4.1 percentage points. In the recent past, elastic global supply has meant that shocks to production or energy have dissipated eventually. Following the Iraqi invasion of Kuwait in the 1990s, for example, oil prices fell below their pre-war level after around five months. And following the Japanese earthquake and nuclear disaster in 2011, production is estimated to have returned to normal after only seven months for Japanese firms. [4]  But the shocks triggered by the pandemic and the war have also created what I have previously called a “new global map” of economic relationships. [5] The economic turning points on this new global map imply that supply constraints are likely to last longer than in the past. And this means, in turn, that it is taking longer for the inflationary effects of those shocks to fade out. Two issues are worth considering here. First, geopolitics have shaken up European energy markets. The cut in gas supplies owing to the Russian invasion has become a major structural change which will have ramifications for several years. For example, following the two oil shocks of the 1970s – the OPEC embargo and the Iranian revolution – the effect on oil prices was still persistent after three years.