In the Eurozone, reflation is not synonymous with stagflation.
The extent and duration of the current inflation rise will undoubtedly be great on the agenda when the world's top central bankers virtually assemble for this year's ECB Annual Forum. However, we believe that the present cyclical pricing pressures are unlikely to become a long-term trend. Even if the pandemic is uncharted ground, the recent high comeback in inflation is a consequence of the extraordinary conditions and hence expected to be transitory. While the initial boost to services has subsided, supply-chain problems have kept input costs and supplier delivery times at all-time highs since the beginning of the year.
Sharply rising energy costs have also driven up headline inflation, which is expected to stay elevated in the coming months as the economy gains traction.
We anticipate average annualized HICP inflation of 2.2 per cent and 1.5 per cent in 2021 and 2022, respectively, consistent with previous European Commission and ECB predictions, with adverse base effects to rein down inflation pressures in the second half of 2022 following the "inflation spike" in H2 2021.
Long-term inflation expectations appear to be well-anchored. Even while professional analysts have marginally raised their inflation forecasts for the next five years, headline inflation remains much below the ECB's objective.
Things may grow worse before they get better. While inflation appears to have slowed during the summer, pandemic-induced supply chain disruptions have worsened as high demand and Covid-19 outbreaks in Asia exhaust transportation capacity, causing workforce and material shortages, particularly in manufacturing and construction.
It may take some time to normalize as manufacturers hurry to refill amid record-large domestic production deficits and low stockpiles, accelerating the volume and price rebound. Construction/building has the most material shortages, which are also significant in electrical equipment metal and nonmetal items. Previous evidence of recovery durations implies that it may take more than three quarters for some industries to fix present shortages (and nearly two quarters for all industries on average), bringing us to the end of Q1 2022.
In addition, the Eurozone, like other advanced countries, is experiencing labour shortages in several areas, which may exacerbate inflationary pressures. We discovered that recovery periods are more than a quarter longer in the most impacted industries, many of which are also experiencing material shortages.
If partial unemployment programs are not entirely phased out by the end of the year, and if slow (re-)hiring by offering improved working conditions, including higher salaries, leads to extended recovery-related labour reallocation, labour scarcity may intensify.
Despite the Eurozone's economic momentum weakening throughout the summer, the recovery is expected to be partial and uneven, with real growth anticipated at +5.0 per cent and +4.2 per cent in 2021 and 2022, respectively. The present slack in the Eurozone remains significant, with production in Q2 2021 being more than -2.5 per cent lower than before the pandemic. While most Eurozone nations will return to pre-crisis activity levels by the end of 2021, production gaps remain significant, with substantial dispersion between countries.
However, the present level of uncertainty about inflation will put the ECB's credibility to the test and how it communicates its monetary policy while "seeing through" the current cyclical price pressures. For the time being, the risks of significant second-round impacts from rising headline inflation look limited, with inflation expectations remaining well-anchored and pricing pressures above the long-term average restricted to a few industries. The first signs of trouble will most likely appear in the changing inflation forecasts. If increased inflation creates a cycle of wage pressures, higher inflation expectations might become a self-fulfilling prophecy through pricing and wage setting.
Scaling back unconventional measures and raising policy rates sooner would be required if evidence of inflation persistently exceeding the price objective emerges before inflation expectations become unanchored.