## Euro Area Inflation after the Pandemic and Energy Shock: Import Prices, Profits and Wages (Working Paper No. WP/2023/131)

## Source details

**Canonical URL:** [Euro Area Inflation after the Pandemic and Energy Shock: Import Prices, Profits and Wages (Working Paper No. WP/2023/131)](https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023131-print-pdf.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2023/english/wpiea2023131-print-pdf.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2023/english/wpiea2023131-print-pdf.pdf.json)

---

### Introduction and purpose
- Investigates the role of profits, wages, and import prices in the recent episode of high inflation in the euro area by decomposing the consumption deflator in addition to the standard GDP deflator decomposition.
- Motivated by observations of sharp increases in firm unit profits alongside rising GDP deflator and discussion of distributional conflict as a source of inflation.

### Key quantitative findings
- Import prices account directly for 40 percent of consumption-deflator inflation on average since 2022.
- Domestic profits account for just below 45 percent of consumption-deflator inflation since 2022.
- Labor costs account for 25 percent of consumption-deflator inflation since 2022.
- Net taxes contributed negatively (were slightly disinflationary) over the period.
- The terms of trade are estimated to contribute negatively to inflation in the euro area over the next two years—on the order of one percentage point in 2023 based on the assumptions underlying the April 2023 IMF World Economic Outlook.
- Latest national accounts data available at the time of writing (Q1 2023) show a further increase in the contribution of unit profits and unit labor costs relative to the 2022 average.

### Decomposition framework and data
- GDP from the income side: GDP = GVA + Net Taxes = Profits + Compensation of Employees + Net Taxes (equation 2.1).
- GDP deflator identity: GDP Deflator = Unit Profits + Unit Labor Cost + Unit Taxes (equation 2.2).
- Consumption price model: p = (1+τ)∏(p_js^λ_js) with Cobb-Douglas weights λ_js and consumption deflator inflation given by equation (3.1): ln p − ln p̃ = ∑λ_js (ln p_js − ln p̃_js) + ln(1+τ) − ln(1+τ̃).
- Sectoral GVA deflator inflation decomposed into labor and profit contributions (equation (3.2)).
- Four data sets required: i) nominal and real sectoral GVA, ii) sectoral nominal labor compensation (or profit), iii) share of sectoral value added in consumption, iv) sales tax rate proxy.
- Sectoral value-added shares for the HICP consumption bundle proxied using OECD TiVA (year 2018) due to lack of ideal data.
- Note: consumption deflator includes import prices and excludes export prices, producing differences with the GDP deflator.

### Empirical contributions to consumption-deflator inflation (2022Q1–2023Q1)
- Foreign (imported) component:
  - Contributed about two fifths to total consumption deflator inflation.
  - Comparable to the contribution from energy to HICP inflation.
- Domestic profits:
  - Contributed 45 percent to total consumption deflator inflation.
- Labor compensation:
  - Contribution smaller than profits and import prices but picking up in recent quarters.
- Sectoral patterns:
  - Unit profits increased markedly in mining and utilities (largest increase), agriculture, construction, manufacturing, and contact-intensive services.
  - Some sectors (professionals, public administration) remained below pre-COVID levels.
  - Mining and utilities moved to account for two tenths of average inflation between 2022Q1 and 2023Q1.
  - Manufacturing’s contribution declined from around one quarter to around one tenth.

### Productivity decomposition and dynamics
- Unit labor cost = nominal compensation per worker − labor productivity (real output per worker) effect.
- Unit profit = capital rent (nominal profit per real capital) − capital productivity (real output per capital) effect.
- For 2022 (average 2022Q1–2023Q1 observations):
  - Unit labor costs accounted for about 1.5 percentage points of average consumption deflator inflation.
    - Compensation of employees accounted for 2 percentage points.
    - Rise in labor productivity accounted for −0.5 percentage points.
  - For the GDP deflator over the same period:
    - Profits accounted for close to 2.5 percentage points of average GDP deflator inflation.
      - Capital rent accounted for around 3¼ percentage points.
      - Capital productivity had a dampening impact of about ¾ percentage points.
- Labor productivity dropped sharply in 2023Q1 relative to Q4 2022 but only moderately relative to 2022Q1; continued productivity declines would reduce room for wage growth, ceteris paribus.
- Limitation: decomposition of unit profit for the consumption deflator is not feasible at quarterly frequency due to lack of sectoral capital stock data.

### Profitability, markups, and distributional implications
- Nominal unit profits and the profit share can increase without an increase in markups because unit profit = η·MC; an increase in marginal cost (MC) raises unit profit even with constant markup.
- Profit share in GVA: η / (W L / MC + η).
- Production-function scenarios (wages constant):
  - Cobb-Douglas (elasticity of substitution = 1): labor cost share and profit share remain constant.
  - Leontief (elasticity = 0): labor cost share decreases and profit share increases.
  - CES (elasticity between 0 and 1): partial substitution leads to labor cost share decreasing and profit share increasing.
- Empirical signals:
  - Profit share has risen to the highest level since the Great Financial Crisis.
  - As of Q1 2023:
    - Profits (adjusted for the GDP deflator) were about 1 percent above the pre-pandemic (2010-2019) trend.
    - Compensation of employees (adjusted for the GDP deflator) stood about 2 percent below trend.
  - Profitability indicators give mixed signals: some proxies show sharp increases in 2021 and reversals in 2022; others show elevated levels since mid-2021 but 2022 not much above pre-pandemic.
  - Sectoral evidence: markup increases in retail and construction in Germany; mixed evidence in Italy; no broad industry-wide increase documented in the presented national-account proxies.
- Explanations for resilient or increased profits:
  - Temporary pricing power amid strong demand, capacity constraints, windfall profits in specific sectors (e.g., mining, some electricity producers), and pandemic- or supply-disruption-induced temporary market power.

### Historical and cross-country comparisons
- Magnitude: the increase in the GDP deflator following the current energy shock is comparable to the 1973 oil price shock, though from a much lower pre-shock inflation level.
- Composition: 1973 featured accelerating labor costs while profits fell; the current episode is more tilted toward profits so far.
- Historical dynamic: in 1973, 1979, and the current episode the relative contribution from labor costs grew over time.
- Cross-country: relative to the US and Canada, the euro area’s recent GDP deflator increase has been more tilted toward profits; Canada and the United States saw earlier accelerations biased toward labor costs and deceleration in H2 2022, whereas the euro area and the UK saw acceleration in H2 2022 with a large role for profits.

### Scenario mapping and outlook
- Scenario assumptions:
  - Terms of trade contribute negatively to inflation on the order of one percentage point in 2023 (April 2023 WEO assumptions).
  - No change in tax rates.
  - Labor productivity remains broadly flat over the next couple of years.
- Simulation insights:
  - Average nominal wage growth of around 4.5 percent over 2023–24 is consistent with April 2023 WEO inflation projections (convergence to target in early/mid 2025) if profit shares return to the 2015–19 average by end-2024 and labor productivity remains broadly unchanged.
  - Static nominal wage growth of around 5.5 percent would restore real wages to their pre-pandemic level by end-2024 but would leave inflation notably higher unless the profit share compresses to the lowest level since the mid-1990s.
  - Conditional on a drop in the profit share by 0.7 percentage points in 2023, all combinations of nominal wage growth and profit share on the model’s mapping yield inflation over 2023-24 consistent with the IMF April 2023 WEO projections; positions above the calibration line imply higher inflation, below imply lower inflation.
  - The April WEO projection for the change in the consumption deflator is 4.9 and 2.5 percent in 2022 and 2023, respectively.
- Risks:
  - The Q1 2023 drop in labor productivity implies upside risks to the inflation outlook if productivity remains weak.
  - Foreign component (terms-of-trade improvement) is expected to help disinflation in 2023; the study estimates a direct lowering of inflation by 0.7 percentage points in 2023 conditional on the WEO terms-of-trade assumptions.

### Policy implications and recommendations
- Monetary policy should continue to anchor expectations at target; tight policies are needed to anchor expectations and maintain subdued demand so economic actors settle on relative price setting consistent with disinflation.
- Given Europe is a net energy importer, the adverse terms of trade shock implies national income must fall relative to the counterfactual; this can be achieved by depressing real profits and/or real wages. Monetary policy is not the right instrument to influence the distribution between profits and wages.
- To achieve disinflation while allowing real wage recovery, a compression in the profit share to historical norms by end-2024 will likely be necessary under plausible wage growth assumptions (e.g., nominal wage growth around 4.5 percent).
- Policymakers should anchor expectations and support coordination among economic actors on a low-inflation equilibrium so recovery in real wages occurs at a measured pace and firms accept a compression in the profit share.
- Policy attention to market power: pursue competition policy and related tools, with further work on sectoral and country heterogeneity to inform targeted interventions.

*Source: wpiea2023131-print-pdf — https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023131-print-pdf.pdf*

### 1. INTRODUCTION _______________________________________________________________________________ 5

### 1. INTRODUCTION

### Context and purpose
- The paper investigates the role of profits, wages, and import prices in the recent episode of high inflation in the euro area, disentangling import prices, profits, and wages in a consumption deflator decomposition in addition to the standard GDP deflator decomposition.
- Motivation: policymakers and commentators noted sharp increases in firm profits (unit profits) alongside rising GDP deflator; examples cited include comments by ECB executive board members and discussion of distributional conflict as a source of inflation.

### Key quantitative findings
- Import prices account directly for 40 percent of consumption-deflator inflation on average since 2022.
- Domestic profits account for just below 45 percent of consumption-deflator inflation since 2022.
- Labor costs account for 25 percent of consumption-deflator inflation since 2022.
- Net taxes contributed negatively (were slightly disinflationary) over the period.
- The terms of trade are estimated to contribute negatively to inflation in the euro area over the next two years—on the order of one percentage point in 2023 based on the assumptions underlying the April 2023 IMF World Economic Outlook.
- Latest national accounts data available at the time of writing (Q1 2023) show a further increase in the contribution of unit profits and unit labor costs relative to the 2022 average.

### Decomposition and data definitions
- GDP from the income side: GDP = GVA + Net Taxes = Profits + Compensation of Employees + Net Taxes (equation 2.1).
- GDP deflator identity: GDP Deflator = Unit Profits + Unit Labor Cost + Unit Taxes (equation 2.2).
- “Profits” in the analysis refers to gross operating surplus and mixed income as reported in national accounts (gross operating surplus is gross of consumption of fixed capital).

### Sectoral patterns
- Unit profits increased markedly in: mining and utilities (largest increase), agriculture, construction, manufacturing, and contact-intensive services.
- Some sectors (professionals, public administration) remained below pre-COVID levels.
- Contributions to total GDP-deflator inflation since 2022: trade, travel, accommodation and food exhibited a significant increase in unit profit and a sizable share of total gross value added; mining and utilities moved from a negligible role to responsible for two tenths of average inflation between 2022Q1 and 2023Q1; manufacturing’s contribution declined from around one quarter to around one tenth.

### Comparison with past energy shocks and other economies
- Magnitude: the increase in the GDP deflator following the current energy shock is comparable in magnitude to the first oil price shock of the 1970s (1973), though starting from a much lower pre-shock inflation level.
- Composition: the 1973 oil shock featured accelerating labor costs while profits fell; the current episode has been more tilted toward profits so far.
- Historical dynamic: in all three episodes (1973, 1979, current), the relative contribution from labor costs grew over time—consistent with wages adjusting more slowly than prices.
- Cross-country differences: relative to the US and Canada, the euro area’s recent GDP deflator increase has been more tilted toward profits; Canada and the United States saw earlier accelerations more biased toward higher labor costs and showed deceleration in year-on-year GDP deflator in H2 2022, whereas the euro area and the UK saw acceleration in H2 2022 with a large role for profits.

### Implications for profitability and distribution
- Nominal profits have increased sharply, and firms have been relatively more shielded from the adverse terms of trade shock than wage earners; however, this does not necessarily imply that profitability (markup or profit margin) has increased.
- National-account evidence for the euro area is broadly consistent with constant rather than increasing profitability (markup) overall, though sectoral evidence shows markup increases in some sectors in some countries (e.g., construction, retail, accommodation, transport in Germany; mixed evidence in Italy).
- A reason for firms being better shielded than workers is greater price flexibility relative to wage rigidity (wages often set by previous negotiations and other rigidities).

### Theoretical and literature connections
- The analysis relates to frameworks viewing inflation as distributional conflict over relative prices (Werning and Lorenzoni, 2023) and classic cost-push inflation theories (Blanchard, 1986), which imply wage acceleration may follow initial price shocks.
- The paper complements firm-level market-power literature but focuses on national-account data and links to recent central bank and research institution findings (ECB, Bank of England, Bank of Italy, European Commission, ESM, IMF work).

### Policy-relevant scenarios and simulations
- Illustrative simulations map inflation outcomes in the profit share–nominal wage growth space using the consumption-deflator decomposition under assumptions:
  - Terms of trade contribute negatively to inflation (on the order of one percentage point in 2023 based on April 2023 WEO assumptions).
  - No contribution of net taxes to inflation.
  - Labor productivity remains broadly flat over the next couple of years.
- Scenario findings:
  - Average nominal wage growth of around 4.5 percent over 2023–24 is consistent with the inflation projections in the April 2023 World Economic Outlook for the euro area (which show inflation converging to target in early/mid 2025) if profit shares return to the average level of 2015–19 by end-2024 and labor productivity remains broadly unchanged.
  - Static nominal wage growth of around 5.5 percent would ensure that real wages return to their pre-pandemic level by end-2024, but inflation would be notably higher unless the profit share compresses to the lowest level since the mid-1990s.
- Policy implications:
  - To achieve disinflation while allowing real wage recovery, a compression in the profit share to historic norms will likely be necessary under plausible wage growth assumptions.
  - Policymakers should anchor expectations and support coordination among economic actors on a low-inflation equilibrium so recovery in real wages occurs at a measured pace and firms accept a compression in the profit share.

*Source: wpiea2023131-print-pdf — https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023131-print-pdf.pdf*

### 3. Decomposing the Consumption Deflator

### 3. Decomposing the Consumption Deflator

### Conceptual distinction and motivation
- The GDP deflator excludes import prices and includes export prices, so it can decouple from consumer price measures (HICP/CPI and the total consumption deflator) especially during large terms-of-trade swings.
- The consumption deflator and HICP developments are more tightly linked because both include import prices of consumer goods and exclude export prices.
- For European countries, foreign GVA accounts for about 20 percent of total consumption.

### Decomposition framework (concept and equations)
- Consumption is produced with a Cobb-Douglas production function with weights 휆푗푠 for value added from country j sector s (∑휆푗푠 = 1).
- Producer cost for one unit of total consumption: ∏(p푗푠^휆푗푠) across j,s, with sector-country cost share equal to 휆푗푠.
- Retailer applies a constant markup; consumption price p = (1+τ)∏(p푗푠^휆푗푠).
- Consumption deflator inflation:
  - ln p − ln p̃ = ∑휆푗푠 (ln p푗푠 − ln p̃푗푠) + ln(1+τ) − ln(1+τ̃)   (equation (3.1)), where ̃ denotes last period.
- Sectoral GVA deflator inflation ln p푗푠 − ln p̃푗푠 can be decomposed into labor and profit contributions:
  - ln p푗푠 − ln p̃푗푠 = (L푗푠/y푗푠 − L̃푗푠/ỹ푗푠 / p̃푗푠) [contribution from labor] + (F푗푠/y푗푠 − F̃푗푠/ỹ푗푠 / p̃푗푠) [contribution from profit].  (Equation (3.2) in text)

### Data requirements and practical implementation
- Four data sets required:
  1. Nominal and real sectoral GVA to calculate sectoral GVA deflator inflation.
  2. Sectoral nominal labor compensation (or profit) to split GVA deflator inflation into labor and profit.
  3. Share of sectoral value added in consumption.
  4. Sales tax rate to compute net tax contribution.
- i) and ii) obtainable from quarterly national accounts; iv) proxied by Eurostat’s difference between inflation and inflation under constant tax rates.
- For iii), ideal sectoral value-added shares for the HICP consumption bundle are unavailable; the study uses sectoral value added for total consumption (private and government) from the OECD’s TiVA dataset (as of year 2018).
- Note: total GDP deflator inflation can also be written as a weighted average of sectoral GVA deflator inflation with weights equal to sectoral real GVA shares; weights differ between the GDP deflator and total consumption deflator because of imports and different sectoral consumption vs GDP shares.

### Empirical findings: contributions to recent consumption deflator inflation
- Period analyzed: 2022Q1 to 2023Q1.
- Foreign (imported) part:
  - Contributed about two fifths to the total consumption deflator inflation.
  - The foreign contribution is closely linked to the terms of trade and comparable to the contribution from energy to HICP inflation.
- Domestic profits:
  - Contributed 45 percent to the total consumption deflator inflation.
- Historical comparison:
  - Rising import prices and profit contributions have replaced labor cost as the main counterparts to inflation over the past two years.
  - With the reversal of energy prices, the import-price contribution has been decreasing since its peak in mid-2022.
  - Contribution from labor compensation has been gradually picking up over recent quarters, similar to previous energy price shocks.

### Productivity effects on inflation components
- Unit labor cost decomposed into nominal compensation per worker and labor productivity (real output per worker).
- Unit profit decomposed into capital rent (nominal profit per real capital) and capital productivity (real output per capital).
- For 2022 (Figure 6 observations):
  - Unit labor costs accounted for about 1.5 percentage points of the average consumption deflator inflation between 2022Q1 and 2023Q1.
    - Within that, compensation of employees accounted for 2 percentage points, and rise in labor productivity accounted for −0.5 percentage points.
  - For the GDP deflator over the same period:
    - Profits accounted for close to 2.5 percentage points of average GDP deflator inflation between 2022Q1 and 2023Q1.
      - Capital rent accounted for around 3¼ percentage points.
      - Capital productivity had a dampening impact of about ¾ percentage points.
- Note on productivity dynamics:
  - In 2023Q1 labor productivity dropped quite sharply relative to Q4 2022 but only moderately relative to 2022Q1.
  - If productivity continues to decline through the rest of 2023, the room for wages to grow would be less, all other variables kept equal.
- Limitation: decomposition of unit profit for consumption deflator inflation is not feasible due to lack of sectoral capital stock data at the euro area quarterly frequency.

### Implications for profitability and income distribution
- Unit profits and profit share can increase without a change in markup because unit profit = η·MC; if MC increases, unit profit increases even with constant markup.
- Profit share in GVA equals η / (W L / MC + η), where W L / MC is labor cost share in total cost.
- Illustrative production-function scenarios (wages assumed constant):
  - Cobb-Douglas (elasticity of substitution between labor and energy = 1): labor cost share and profit share remain constant.
  - Leontief (elasticity = 0): labor cost share decreases and profit share increases.
  - CES (elasticity between 0 and 1): partial substitution of energy by labor; net effect is labor cost share decreases and profit share increases.
- Empirical evidence:
  - Profit share has risen to the highest level since the Great Financial Crisis (GFC) (Figure 7).
  - As of Q1 2023:
    - Profits (adjusted for the GDP deflator) were about 1 percent above the pre-pandemic (2010-2019) trend.
    - Compensation of employees (adjusted for the GDP deflator) stood about 2 percent below trend.
- Available profitability indicators (Figure 8) give mixed signals:
  - A sectoral account-based proxy for overall profit margins shows a sharp increase in profitability in 2021 but a reversal in 2022.
  - A proxy closer to pre-tax corporate profits shows elevated levels since mid-2021 but 2022 levels not much above pre-pandemic levels.
  - A microdata proxy for firm-level markups shows a rebound from the pandemic low in 2021; 2022 data for that dataset not yet available.
- Possible explanations for resilient or increased profitability:
  - Temporary pricing power amid strong demand so markups did not need to fall.
  - Capacity constraints in competitive markets or market structures allowing windfall profits (e.g., mining, some electricity producers).
  - Pandemic and energy shocks may have led to situations generating unusual profits in otherwise competitive markets (higher prices rationalized by upward-sloping marginal cost curves).
  - Supply disruptions could produce temporary monopolies/oligopolies, increasing pricing power.
  - Sectoral examples: contact-intensive sectors (food services, travel) benefited from pent-up demand and reduced capacity; construction raised prices due to buoyant demand and scarcity; agriculture and manufacturing benefited from rising global commodity prices.
- Empirical nuance:
  - National-account markup proxies show retail and construction markups increased in Germany but not in Italy; no increase in markups in industry and manufacturing in the evidence cited.

### Implications for the inflation outlook and scenario mapping
- Use of decomposition to map nominal wage growth and profit-share scenarios into consumption deflator inflation over the next two years.
- Assumptions for scenario mapping:
  - No change in tax rates.
  - Constant labor productivity.
- Rewriting consumption deflator inflation (under these assumptions):
  - ln p − ln p̃ = ∑휆푗푠 (ln Y푗푠 − ln Ỹ푗푠) [nominal sectoral GVA growth] + ∑휆푗푠(dominestic,s)(ln y푗푠 − ln ỹ푗푠) [foreign real domestic consumption growth].
- Projection approach:
  - Foreign component projected based on historical relationship with growth rate of the terms of trade and the terms of trade for 2023/24 as projected in the IMF’s April 2023 WEO.
  - Real total domestic consumption growth projected from historical relationship with real GDP growth and WEO GDP growth for 2023-24.
  - Projected domestic nominal sectoral GVA growth built from assumptions on labor compensation (e.g., aggregate wage growth assumption plus historical deviations) and profit share assumptions (e.g., return to historical averages).
- Key qualitative insights from simulations:
  - Both an increase of wages relative to profits and a compression in profit shares are plausible going forward.
  - Historical evidence and theory suggest nominal wage pressures are likely to increase following real wage erosion.
  - A compression of the profit share going forward also seems plausible given temporary factors behind recent profitability resilience.
  - Illustrative simulations indicate that compression in the profit share back to the historic average will be necessary to achieve disinflation under plausible wage growth assumptions.
  - The foreign component is expected to help disinflation in 2023 due to a recovering terms of trade; the study estimates it will directly lower inflation by around (text ends here).

_International Monetary Fund_

### 0.7 percentage points in 2023. Conditional on this, all combinations of nominal wage growth and profit share on

### Euro Area Inflation after the Pandemic and Energy Shock: Import Prices, Profits and Wages (Working Paper No. WP/2023/131)

### Key findings on drivers of inflation
- A decomposition of the consumption deflator in 2022 shows that one third of inflation is directly accounted for by import prices, with domestic profits accounting for close to 50 percent.
- Based on available national accounts indicators and other recent studies, the paper finds no conclusive verdict that profitability has increased broadly; the increase in profits reflects firms passing on more than the nominal cost shock but not necessarily increasing profitability.
- Data and measurement constraints loom large when assessing profitability; no evidence is found that would warrant substantial concerns or policy interventions in terms of competition policy based on current indicators.
- Market power remains a structural issue that predates the current inflationary episode and should be addressed through competition policy and related tools.

### Illustrative scenarios and quantitative relationships
- Conditional on a drop in the profit share by 0.7 percentage points in 2023, all combinations of nominal wage growth and profit share that lie on the black line in Figure 9 yield inflation over 2023-24 consistent with the IMF April 2023 WEO projections (convergence of inflation to target in early/mid-2025). The area above the line would lead to higher inflation; the area below the line to lower inflation.
- Historical comparison: 2015-19 average — inflation stood below the 2 percent target, with a profit share around 42 percent and nominal wage growth of around 2 percent.
- Recent outcome: wage growth was 4.5 percent in 2022 and the profit share stood around 42.5 percent.
- If the 2022 combination (nominal wage growth 4.5 percent and profit share 42.5 percent) persisted over 2023-2024, inflation would remain above the path required to converge to target.
- If nominal wage growth is around 4.5 percent over 2023-24, profit shares would have to return to 2015-2019 averages by end-2024 to achieve the baseline inflation projection (the red dot in Figure 10).
- If nominal wages instead increase such that real wages recover to 2019 levels by 2024 (implying nominal wage growth of around 5.5 percent each year), then:
  - the consumption deflator would be around 1 percentage point higher than in the WEO on average over 2023-24,
  - or to keep the inflation path projected in the WEO, the profit share would need to drop by another 0.7 percentage point, reaching the lowest since the mid-1990s.
- Under the higher wage assumption, to reach the WEO consumption deflator inflation projection, the profit share would have to drop noticeably below the historical average (the triangle in Figure 10).
- Given the drop in labor productivity observed in Q1 2023, there are risks to the stable labor productivity assumption embedded in the exercise; this suggests upside risks to the inflation outlook.
- The April WEO projection for the change in the consumption deflator is 4.9 and 2.5 percent in 2022 and 2023, respectively.
- Note: real wages (adjusted for HICP) would still be significantly below their pre-COVID trend even if they regain their end-2019 level by 2024. This scenario is thus not necessarily inconsistent with the needed adjustment in income to the terms of trade shock.

### Policy analysis and recommendations
- Monetary policy should continue to anchor expectations at target; tight policies are needed to anchor expectations and maintain subdued demand so that economic actors settle on relative price setting consistent with disinflation.
- Given Europe is a net energy importer, the adverse terms of trade shock implies that national income must fall (relative to counterfactual). This can be achieved by depressing real profits and/or real wages. Monetary policy is not the right instrument to influence the distribution between profits and wages.
- A normalization of profit shares to historical averages by end-2024 and nominal wage growth around 4.5 percent would be consistent with inflation converging back to target by mid-2025, assuming productivity stays broadly unchanged.
- Policymakers should remain attentive to market power and pursue competition policy and related tools; more work on sectoral and country heterogeneity is warranted to provide important insights to policymakers.

*Source: Euro Area Inflation after the Pandemic and Energy Shock: Import Prices, Profits and Wages — Working Paper No. WP/2023/131 (International Monetary Fund).*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2023/english/wpiea2023131-print-pdf.pdf_