Is Inflation coming? Part I: Drivers of Inflation in the short run

In October 2021, prices paid by consumers in the eurozone were four percent higher than in October 2020 – the highest rate of increase since the summer of 2008. Effects of the corona pandemic are responsible for this. When these expire, we can expect lower inflation rates as early as next year.

Inflation – what is it?

Inflation describes a situation in which the prices of goods – particularly consumer goods – rise over time. In market economies, prices rise when aggregate demand for goods exceeds supply. If, on the other hand, aggregate demand for goods is lower than aggregate supply, prices fall.

In addition to these demand-side inflationary tendencies, there are also supply-side inflationary causes. These result from rising production costs. If these costs can be passed through to the market, prices rise. Conversely, if production costs decline and that can be passed through to the market, prices fall.

The relationship between demand for goods and supply of goods is particularly evident in times of economic crisis because abrupt changes in supply and demand occur. Examples are the global financial and economic crisis following the Lehman bankruptcy in September 2008 and the global economic crisis triggered by the corona pandemic.

Such economic crises lead, among other things, to private households reducing their consumer spending. They do this either voluntarily because they are building up savings for an uncertain future or involuntarily because they lose their jobs and therefore only have a lower income.

As the following chart shows, consumer prices in the eurozone rose at a noticeably slower pace with the outbreak of each of the two crises mentioned above. In some phases of the crisis, there was even a decline in prices, i.e., deflation – the rate of change in consumer prices had a negative sign.

consumer prices in euro area

At the same time, the figure shows that as economic activity picks up, there is a more substantial increase in consumer prices. Even though the basic pattern of consumer price development is similar in the two economic crises, the price increase after the corona pandemic is noticeably stronger than after the global financial and economic crisis of 2008/09. This is mainly because the gap between aggregate demand and supply in this phase of the economic recovery is – at least temporarily – larger than after the financial and economic crisis of 2008/09.

Inflation Drivers in the Corona Pandemic

We see four key causes for the sharp rise in consumer prices in Europe during the corona pandemic:

  • #1 Upswing with rising energy prices: Immediately after the outbreak of the corona pandemic in Europe and the U.S., noticeably fewer consumer goods were purchased. Companies adapted to the drop in demand and reduced their production – thereby reducing the demand for raw materials, especially fossil fuels. Accordingly, their prices fell with the outbreak of the corona pandemic, especially in March and April 2020. When prices rose again with the economic recovery, they were significantly higher in the same months of 2021. However, this is a one-time effect.
  • #2 Strong global demand growth: The global economic catch-up since summer and fall 2020 has led to higher demand for raw materials and intermediate inputs, whose prices therefore rose. Additionally, the outbreak of the corona pandemic led to a shortfall in intermediate inputs from China and Asia. Companies in Europe that work with inventories have now used them up. The replenishment of these stocks is causing an additional surge in demand for raw materials and intermediate inputs. And government stimulus packages are boosting overall demand for goods and also having an inflationary effect.
  • #3 Lack of production capacity: When demand for goods plummeted with the outbreak of the corona pandemic, many companies around the world scaled back their production capacities, i.e., laid-off employees and cut back on investment. It is, however, not always possible to ramp up capacity again overnight. Employees may have looked for new jobs and are no longer available to their original employers. As a consequence, companies’ inventory cannot be adjusted immediately to meet the higher demand. The resulting excess demand has the effect of raising prices worldwide. 
  • #4 Disruption of global transport routes: Even if raw materials, inputs, and end products are available, they cannot always be transported promptly to where they are needed. This applies above all to the availability of containers: In Asia in particular, port workers are repeatedly absent due to quarantine caused by corona. Containers are not unloaded and are then not available for future transport, leading to supply bottlenecks in Europe. The blockade of the Suez Canal by the container ship “Ever Given” in spring 2021 exacerbated these bottlenecks.

Europe and the U.S. in comparison

The developments outlined above apply not only to Europe but also to the U.S. economy. There, too, the economic upturn has been accompanied by a noticeable rise in consumer prices. The rise is currently even higher than in the eurozone. The main reason for this is the enormous size of the American economic stimulus packages put together to boost the economy.

consumer prices in euro area chart

The different inflation rates in the eurozone and the U.S. have had an impact on the exchange rate, i.e., the value of the euro compared to the U.S. dollar.

Since the summer of 2020, the inflation rate in the U.S. has been higher than that in the eurozone. Normally, a high inflation rate leads to a devaluation of the currency concerned – in this case, the dollar: High price increases in the U.S. reduce the international competitiveness of American products in the rest of the world. If the U.S. sells less abroad, foreign countries need fewer dollars. So demand for U.S. dollars declines, and that causes the dollar to depreciate – and the euro to appreciate. The euro did, in fact, experience an appreciation between the summer of 2020 and early 2021.

Since then, however, we’ve seen euro depreciation and dollar appreciation -. despite the fact that the difference between the U.S. and eurozone inflation rates has actually widened in recent months. How can this be explained? We suspect the following connection: High inflation rates are combated by restrictive monetary policy by the central bank. This means the central bank reduces its ability to lend to commercial banks, leading to higher interest rates.

However, the pressure to raise interest rates is greater in the U.S. than in the eurozone because of the higher inflation rates in the U.S. So the prospect that the U.S. Federal Reserve will raise interest rates sooner than the eurozone central bank motivates capital investors to buy dollars.

When interest rates are higher in the U.S. than in the eurozone, it becomes more attractive for investors to withdraw their money from the eurozone and invest it in the U.S. instead, thus earning higher interest rates. Rising dollar demand causes the dollar to appreciate, while flight from the euro leads to euro depreciation.

To profit from the expected appreciation of the dollar, it is already worthwhile to buy dollars. This increased demand for dollars causes an appreciation of the dollar and a depreciation of the euro – a development that we have been seeing since summer 2021 at the latest.

daily euro reference rate European Central Bank


The disruptions to global supply chains caused by production stoppages and disruptions to shipments, which are currently driving up prices, are temporary phenomena that should ease during the course of 2022. This is shown in the European Commission’s report on economic developments in the euro area published in November 2021: consumer prices are forecast to rise by 2.4 percent in 2021 compared with 2020. The inflation rate predicted for 2022 is 2.2 percent, and then “only” 1.4 percent is expected for 2023.

However, this does not mean that the issue of inflation will disappear from the economic policy agenda. Global demographic change, climate change, the increase in emission-containing activities in the course of climate protection, and deglobalization trends are likely to lead to rising prices for goods in the coming decades. We will cover these aspects of inflation in a second blog post next week.