Why inflation is likely to remain high

The ECB and a large majority of economists assume that inflation will fall further to 2% in 2025 and that we will be back to business as usual.

Dr. Vincent Stamer, Christoph Weil

Commerzbank Economic Research

May 17 2024

We do not share this optimism and expect the inflation rate to be closer to 3%. On the one hand, wage costs will continue to rise sharply in the coming year and, on the other hand, companies' scope for setting prices will increase as the economy recovers. By spring 2025 at the latest, the ECB is likely to realize that inflation has not been defeated after all and that it will have to end the cycle of interest rate cuts.

Supply bottlenecks following the coronavirus pandemic, a surge in demand due to government coronavirus aid and the energy price shock caused the inflation rate in the eurozone to rise to more than 10% in the fall of 2022. As the shocks subsided, the inflation rate fell back to 2.4% in April and the core inflation rate excluding energy, food and beverages fell from a high of 5.7% in the spring of 2023 to 2.7% most recently. The ECB target of 2% therefore seems within reach. The vast majority of economists and the ECB expect the inflation rate to reach this target again next year.

Higher wage costs push prices up again

However, since the beginning of the year, prices have increased again from month to month. In the first three months of the year, the seasonally adjusted consumer price index excluding energy and food (core index) rose by more than 3% on an annualized basis, and the less volatile 6-month rate of change has also ended its downward trend and is now trending upwards again. This is due to the renewed sharp rise in service prices, while prices for goods (excluding energy and food) have stabilized. The price trend in the individual product groups suggests that the rise in the core index in the second half of last year was also slowed by the indirect effects of lower energy prices. This effect appears to have run its course, meaning that other drivers such as the sharp rise in wage costs are now once again dominating the price trend, which is particularly evident in labor-intensive services.

Scarce labor force drives wages

This boost from wage costs is likely to continue. The collective wage agreements already in place suggest that collectively agreed wages will increase by an average of more than 4% over the remainder of this year. As in the past two years, wages actually paid are likely to increase even more strongly. The ECB expects salaries per employee to rise by 4.5% in the current year.

In the coming year, wages are also likely to increase significantly more than in the years before the pandemic, even if the lower inflation rate will probably remove an important driver. This is because the negotiating position of employees remains good. A large number of companies are complaining about a shortage of qualified workers, even if their share has fallen slightly over the past year and a half due to the weak economy. As the economy picks up, the shortage of workers is likely to increase again.

The ageing population is likely to contribute to this more and more. Over the next ten years, this will not only lead to a noticeable reduction in the supply of workers, but will also significantly increase the demand for labor-intensive services such as care for the elderly and healthcare. It is no coincidence that employment in these areas in particular has risen significantly over the past two years. Together, these two effects are likely to further exacerbate the shortage of labor and thus push up wages.The economic upturn should also make it easier for companies to pass on higher wage costs to their customers.