Why is inflation currently so high?

16 November 2021

You may have noticed that filling up your car, going to the hairdresser and shopping for groceries have become more expensive lately. While some things are cheaper than a year ago, overall we are paying more for what we buy. This is what we call inflation.

Why are prices going up faster than before?

After years of very low inflation, in August, September and October 2021 inflation hit its highest level in 13 years. This is happening for three main reasons: our economy is reopening fast, higher energy prices are pushing up inflation, and something that statisticians call the “base effect”.

Our economy is reopening fast

Our economy is reopening quickly as more and more restrictions are lifted. People have started traveling again and going to restaurants. They are buying more, spending some of the money they couldn’t spend during the lockdowns. When an economy is growing, businesses find it easier to raise prices without losing customers. This is what we are seeing today. Eventually, though, people will have caught up on consuming the goods and services that they put off during the pandemic.

But not everything is moving at the same pace. Companies are finding it difficult to keep up with rapidly rising demand as they rebuild supply chains that were badly hit by the pandemic. Challenges such as a shortage of shipping containers mean transporting goods has become more difficult and more expensive. The longer such difficulties persist, the more likely it is that companies will pass these costs on to their customers in the form of higher prices.

The pandemic has also changed the way we live and work, and therefore the things we need. Consumers are buying more of certain products, such as electronics and home improvement supplies, than the companies selling these products had planned for. Important parts like semiconductors are suddenly hard to get. When companies can’t keep up with the pace at which people want to buy things, prices go up. This is what economists call the “law of supply and demand”.

It will take some time, but this imbalance between supply and demand will gradually fade away, as companies produce more microchips and build new vessels.

Higher energy prices are pushing up inflation

Oil, gas and electricity have become more expensive around the world. Many factors influence energy prices: less wind in the United Kingdom meant windmills stood still, droughts in Brazil led to less power from dams, and last year’s cold winter left us with lower oil and gas reserves. Together with growing demand, this caused prices to rise quickly. Because a large part of companies’ and people’s costs relate to energy, the price of oil, gas and electricity matters greatly for overall inflation: half of the recent increase in inflation was due to higher energy prices. Since they are influenced by so many things, it is not unusual for energy prices to move up and down a lot.

Inflation is high today because it was so low last year

To measure inflation, we compare how prices change from one year to the next. Prices were exceptionally low at the height of the pandemic last year, partly driven by a cut in Germany’s sales tax. Comparing today’s higher prices to those very low levels means differences will seem large. This is referred to as the “base effect” and will fade out quite quickly.

So what will happen to inflation next year?

We expect inflation to go down over the course of 2022. Supply will gradually catch up with demand, markets anticipate energy prices will go down next year, and base effects will drop out of the yearly price comparison used to measure inflation.

However, because the pandemic was unprecedented in modern times, this recovery might also be different. It may take longer to repair the massive disruptions to supply chains. Energy prices may continue to rise, also due to the green transition.

We are also keeping a close eye on wages because prices and wages influence each other. Employees and unions are currently asking for pay rises to compensate for higher living costs. This is normal. But if wages continue to increase, businesses may recoup their higher costs by bumping up prices, which pushes up prices even more. If people and businesses start to expect higher inflation to last, actual inflation could rise as well. Economists call this a “second round effect”. So far, however, we have not seen a large increase in wages.

What can the ECB do about all of this?

We are confident that inflation will decline in the course of 2022. Because monetary policy works with some delay, it can’t help against short-lived spikes in prices. Making borrowing more expensive at a time when higher energy and fuel bills are squeezing people’s incomes and companies’ profits would create unwarranted headwinds for the recovery. 

And, higher interest rates won’t solve the imbalance between supply and demand, energy prices and base effects that are currently pushing up prices: they won’t make more shipping containers available or boost the supplies of semiconductors and fuel. But monetary policy can ensure that prices don’t permanently go up at such a rapid pace. We are therefore carefully examining the outlook for inflation over the next years.

Our mission at the ECB is to keep prices stable, which means that we are aiming at an inflation target of 2% in the medium term. That benefits people across the euro area: stable prices help to ensure that the economy is growing, jobs are safe and you can feel confident that the money in your pocket will be worth roughly the same tomorrow as it is today.