The price to pay: How to rein in inflation? Central bank and government perspectives

September 15, 2022

In a matter of just two years, the monetary policy debate in Europe and beyond has shifted from fighting risks of a great depression and great deflation to coping with multi-decades high inflation that shows no signs of abating. Moreover, while the exit from the pandemic was uncharted territory, Russia’s war in Ukraine has fundamentally changed the global outlook.

Today I would like to shed light on three key questions that confront policymakers in Europe:

  • What has been driving the inflation surge and the rise in its dispersion across countries?
  • How is inflation likely to evolve throughout the remainder of 2022 and 2023, and what are the risks around this path?
  • What do inflation prospects and risks imply for the calibration of macroeconomic policies?

    In a nutshell, my answers to these three questions are as follows:

  • Much of the inflation surge can be traced back to soaring energy and food prices, but there is an unexplained part. Neither commodity prices, nor other conventional inflation drivers such as output or employment gaps and inflation expectations, can fully account for the rise in inflation. This holds in particular true for core inflation. At least some of the unexplained part seems to relate to unique pandemic-specific forces. These include the initial rotation of demand towards durable goods, later on towards contact-intensive services, and also rising shortages in input markets.
  • Notwithstanding recent gas price increases, the prospective stabilization or even decline of commodity prices and the projected slowdown in growth should gradually bring down inflation. But that could be a slower process than sometimes assumed, given the persistence of core inflation. Also, while there are large inflation risks both ways, core inflation risks are predominantly on the upside.
  • Central banks should thus continue to raise policy rates under most scenarios—even more clearly in emerging European economies. Fiscal policies should strike the right balance between supporting the monetary policy stance and protecting vulnerable households and viable firms against sharp income losses from skyrocketing energy prices.

Let me now elaborate on each of these points. I will start with an overview of recent inflation dynamics in Europe.

Recent developments

On average across Europe, commodity prices contributed roughly two-thirds of the rise in headline inflation. In some of emerging European economies, food inflation contributed significantly more than energy prices. A prime example are the Western Balkan countries. There the share of food in the consumption basket on average is nearly 40 percent—twice the EU average.

Another striking feature of the inflation surge is how diverse it has been across countries. By August 2022, headline inflation reached between 20-25 percent in the Baltic countries, triple or quadruple the rate in the lowest inflation countries in the euro area. While partly reflecting different cyclical positions, this heterogeneity is also driven by cross-country differences in policies. In particular, energy price caps or freezes have been more prevalent in some countries (France, Malta or Spain, for example) than in others (Estonia).

Inflation pressures have also become increasingly broad-based. By mid-2022, about 70-90 percent of the core CPI basket consisted of items with year-on-year price increases above central banks’ targets.

And domestic services inflation, which is less directly exposed to global food and energy developments, has also soared.

Inflation drivers

Looking beyond simple decompositions, a more in-depth understanding of the drivers of the recent inflation surge can be achieved by analyzing Phillips curves. This workhorse empirical model relates current inflation to lagged and expected inflation, the output gap, and external price pressures—including specifically from global energy and food prices. New estimates forthcoming in our October Regional Economic Outlook reveal three important differences between advanced and emerging European economies.

Inflation in emerging European economies: 1) increases more when labor markets tighten; 2) is less forward-looking; and 3) responds more to foreign price developments, especially global food prices, and also to exchange rates. Together with a higher starting level of inflation prior to the COVID pandemic, these patterns explain why inflation is currently higher in emerging Europe economies than in advanced European economies.

Conventional Phillips curves explain some of the recent rise in inflation, including through large foreign price increases. But by mid-2022, they showed large positive residuals. On average across Europe, roughly 40 to 50 percent of core inflation was unexplained in the second quarter of 2022.

What may account for this unexplained inflation? The jury is still out and more research is needed. But let me offer two possible explanations:

  • There could be a structural change in existing relationships after Europe was hit by two tail-risk events: the pandemic and Russia’s war in Ukraine. For example, we find evidence that inflation in Europe has recently become more backward-looking and more responsive to global commodity prices.
  • Conventional measures of inflation drivers may fail to fully capture COVID-specific forces. For example, the unexplained component of inflation is correlated with a country’s share of firms reporting input or labor shortages. This suggests that conventional output gap estimates may be over-estimating the downward inflation pressure from residual economic slack in European economies.

Prospects and Risks

How is inflation likely to evolve from here? Phillips curve models would predict a gradual fall in headline inflation to 3-4 percent in both advanced and emerging economies over the coming year. Inflation would still remain above central bank targets at the end of 2023.

However, if the large recent Phillips curve residuals that I just mentioned persisted for longer than expected, inflation would fall back to central bank targets more slowly.

Further, a number of inflation risks could materialize. Some are two-sided and not so new, but unusually large at the current juncture—think about the range of economic slack estimates or plausible future paths for commodity prices. Some of the other risks are on the downside, such as a more rapid easing of supply disruptions as demand slows. But most are on the upside and could take us more into uncharted territory: continued inflation surprises may de-anchor inflation expectations. Workers may demand compensation for recent high inflation in the form of higher wages, potentially triggering wage-price spirals.

How much should we be worried about wage-price spirals? At this stage, this risk remains contained, at least in advanced European economies where wage growth has risen to only modest levels so far, and public wage growth is expected to remain contained. Further, formal wage indexation across Europe is far less than it used to be. The sharp ongoing economic slowdown will help moderate wage claims.

But vigilance is called for. Our recent research suggests that the response of wages to price shocks is stronger when prevailing inflation is already high, as it is right now. In other words, persistent high inflation could trigger a change in regime with self-reinforcing increases in wages and prices resulting in entrenched inflation. In such a world, inflation formation may become more backward-looking. As I mentioned, we already see some signs of this happening in the post-COVID period.


What does this mean for policies, and primarily for monetary policy, the first line of defense against inflation? Real interest rates are still below plausible estimates of neutral levels, and currently tight labor markets should remain healthy under our baseline projections. Further, as I argued, there are risks that inflation could well stay uncomfortably high for longer than expected and become entrenched. Therefore, central banks should keep raising policy rates under most scenarios. While generally true across the board, this applies even more in emerging economies. There, inflation is typically higher and more persistent. Risks of an unmooring of inflation expectations are greater. And wage-price spirals are more likely amid already high nominal wage growth and tight labor markets.

At the same time, given very high prevailing uncertainty, monetary policy should remain nimble and data-dependent. To get a rough sense of how much central banks may need to change course should risks materialize, we ran illustrative simulations using a small DSGE model calibrated for advanced and emerging European economies. These simulations suggest that, depending on the countries and scenarios considered, monetary policies could easily need to tighten by up to 200 bps more than expected in our baseline forecasts, reducing GDP growth by up to 2 percentage points in the year ahead. That would be the case, for example, if inflation formation became as backward-looking as it used to be prior to the 1990s.

In any event, preserving central bank independence and policy transparency is key. When monetary policy lacks credibility, inflation expectations are not well anchored, and wages respond more strongly to price shocks. In other words, risks of wage-price spirals are greater.

Let me close with a word on other policy settings. Fiscal measures have a key role to play in cushioning the impact of the transitory component of the energy price shock on vulnerable households and viable firms. Such measures should remain consistent with a non-expansionary fiscal stance in most European economies. Fiscal policy should support, rather than conflict with, monetary policy. Finally, structural reforms remain key to improving energy security, speeding up the green transition and fostering longer-term growth and economic convergence in Europe. Some of them could also incidentally ease supply constraints and support monetary and fiscal policies in the fight against inflation.

Thank you.