You are currently viewing The Eurozone is at risk of entering the phase of "inflationary psychology": What is it and how it works

Inflation in the euro zone had never shown such high rates of change for so long. As this phenomenon continues, new risks appear on the horizon. Philip Lane, chief economist of the European Central Bank, has analyzed the most important ones and has warned that the euro zone could be close to suffering a phase of inflationary psychology, a behavior that threatens to sharpen the rise in prices. Many of the economic concepts that already seemed ‘buried’ in economics textbooks are resurfacing today with force.

Inflation in the euro zone shows a historical variation rate of 8.1% which, presumably, will continue to rise. This trend risks fueling what is known as “inflation psychology,” Philip Lane, chief economist at the European Central Bank, said Monday, referring to a phenomenon in which consumers and businesses adjust their investment decisions. consumption and investment by anticipating higher future inflation.

How does it work?

“We have very high inflation rates right now, and clearly we could be in a world where the psychology of inflation is taking hold”sentenced one of the heavyweights of the Executive Committee of the European Central Bank.

Economic theory holds that once the psychology of inflation is established in the economy, consumers begin to make their purchases in advance to counter rising inflation, while companies start raising their own prices (passing on more of the costs to the consumer), because they expect higher and higher costs. The result of this behavior is higher and longer inflation.

In economic jargon it is often said that this is the equivalent of a reduction in the demand for money. Economic agents choose to a greater extent to hoard goods, services and assets to the detriment of money. This phase is the opposite of what has been going on in the euro zone in recent decades, when the demand for money has been extensive (cash, deposits, international demand for euros…), which allowed the central bank to implement a very expansive monetary policy without generating inflation and without blowing up the euro exchange rate.

However, when the demand for money falls, inflation tends to increase along with a depreciation of the currency, which in turn feeds back into the price spiral itself.

three inflation shocks

Lane explained that the euro zone has faced three inflation shocks since 2021 that have been fueling the rise in prices one after another. At first, the economy had to face a “pandemic cycle with lockdowns and bottlenecks.” During this cycle, companies froze their investment and even reduced their production capacity. Later, with the reopening of the economy, the enthusiasm of households to return to normality and accumulated savings, there was a demand shock that supply could not placate. Prices woke up.

In a slide presentation, Lane explained that closely related to the above is also the energy shock (no investment in new capacity to extract and refine crude, for example), which Lane cites as the second. Global supply disruptions and the global transition to renewable energy shaped this new inflation drive. Finally, the third shock has been the war between Russia and Ukraine, generating new energy problems, bottlenecks and uncertainty, all “with long-term implications.”

New risks for inflation

In addition, Lane recognized that there are up to five risks that, if materialized, could bias inflation forecasts upwards:

-Adjustments in wages to catch up with inflation. This is the main second-round effect that could feed back into inflation and generate a price-wage spiral. Although this risk is unlikely, its materialization seems less preposterous every day. Wages have risen by more than 2.8% in the first quarter of the year, the highest rate since 2009. Meanwhile, strikes and demands for wage increases are taking place in almost all the countries of the euro area.

-Long-term inflation expectations. Today, 10-year inflation expectations seem anchored at 2% in the euro zone. Its disembedding would entail a significant risk for present and future inflation through a change in the behavior of agents, according to the economic literature itself managed by the ECB.

-Inflation psychology. This is the phase that the eurozone could be entering, according to Lane himself.

-Real interest rates. If inflation remains extremely high, real interest rates (the nominal interest rate minus inflation) will remain negative, so monetary policy will continue to lag behind the curve, encouraging consumption and investment. In the end, all these risks have a certain relationship with each other and the materialization of one may mean that the others begin to come into play.

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J. A. Allen

Author, blogger, freelance writer. Hater of spiders. Drinker of wine. Mother of hellions.

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