Inflation: Frequently asked questions

22.06.2022 DE

Why is inflation so high? Will prices continue to rise? And what influence do the ECB and national central banks like the Bundesbank have on inflation? The answers to these and other important inflation-related questions can be found here.

What is inflation and why is it so high at the moment?

Inflation means a broad increase in consumer prices for goods and services for an extended period of time, resulting in a persistent rise in the general price level.
Consumer prices for energy and food, in particular, are currently surging, but price pressures have become significantly more broader-based.
Uncertainty surrounding further developments is great and risks to inflation are tilted to the upside – due, above all, to Russia’s war on Ukraine.
When the prices of not only individual goods increase but consumer prices rise across the board over a prolonged period of time, economists call this inflation. In May 2022, the inflation rate in Germany as measured by the Harmonised Index of Consumer Prices (HICP) rose to 8.7% (8.1% in the euro area). On an annual average for 2022, HICP inflation is likely to amount to 7.1% in Germany, according to the latest Bundesbank projection (see the link below). For the euro area, Eurosystem experts have most recently forecast an annual average inflation of 6.8% for the current year. The inflation rate is then expected to gradually decline again up to 2024, to slightly over 2%. This would still put it higher than the ECB Governing Council’s inflation target of 2% in the euro area over the medium term, however.
The current high inflation rates are chiefly due to the rapid rise in energy and food prices. Energy prices had already climbed steeply prior to the war in Ukraine. In the current Monthly Report, the Bundesbank’s economists write that the war and its repercussions have exacerbated price pressures which were already high anyway. In addition, pressure on prices has become significantly more broadly-based, whilst inflation excluding food and energy in Germany, which stood at 4.0% at last count, is also far higher than the historical average (1.1%).
“Price pressures have even intensified again recently, which is not fully reflected in the present projections,” stressed Bundesbank President Joachim Nagel with regard to his institution’s current projections for Germany, adding that if this development continues, the annual average HICP rate for 2022 could be well above 7%.
Starting next year, inflation in Germany is likely to decline gradually. According to the projections, the HICP rate could contract to 4.5% in 2023 and to 2.6% in 2024. “Euro area inflation rates won’t fall by themselves,” according to President Nagel. “Monetary policy is called upon to reduce inflation through resolute action.”

Further information

Bundesbank projections: Economic recovery likely to continue

10.06.2022 Press release Deutsche Bundesbank

Inflation rate expected to be +7.9% in May 2022 30.05.2022 | Statistisches Bundesamt – Press release #221

destatis.de

Outlook for the German economy for 2022 to 2024 Article from the Monthly Report June 2022

10.06.2022 | 459 KB, PDF

Why do energy prices have such a major impact on inflation?

On average, energy expenditure accounts for just over 10% of all consumer spending.
Consumer prices for energy fluctuate much more strongly than the prices of many other goods and services.
If energy becomes more expensive, so does the production of many other goods and services.
Taken in isolation, energy expenditure already accounts for an average of just over 10% of households’ spending (as measured by the HICP). Changes in energy prices can therefore have a significant impact on the inflation rate. Compounding this is the fact that the prices of energy sources such as oil or gas often fluctuate very sharply on the commodity markets. Consumers do not purchase crude oil directly, but buy it in the form of petrol and diesel or heating oil. They therefore notice very quickly when prices for energy raw materials change: for instance, if crude oil prices decrease, prices of fuel and heating oil also tend to decline. When oil becomes more expensive, this is rapidly reflected in higher prices at the pump or heating bills. If natural gas prices rise, this also results in higher electricity prices, owing to the fact that electricity production is reliant on natural gas. Ultimately, the manufacture and distribution of a great number of products and services requires energy – from food or clothing to holidays or a new haircut that has to be blow-dried into the right shape. When energy becomes more expensive, many other goods and services often gradually follow suit.

Why not an inflation target of zero percent?

To counter statistical measurement errors
In order to maintain a “safety buffer” against deflation (a general, persistent decline in the price level).
The ECB Governing Council considers that price stability is best maintained by aiming for a 2% inflation rate (as measured by the HICP) over the medium term. But wouldn’t unchanged prices – i.e. an inflation target of zero percent – be best for all concerned? No, and there are good reasons for this.
For one thing, certain errors in statistical price measurement need to be taken into account. These measurement errors could result in inflation rates officially measured by statistical offices being somewhat higher than the actual inflation rate.
A moderate rise in prices also affords a safety buffer against deflation, i.e. a general persistent decline in the price level. A safety buffer is advisable because deflation is associated with the risk of the economy plunging into a downward spiral.
A deflationary downward spiral is difficult to counter with monetary policy measures because the (nominal) interest rates cannot be lowered significantly below zero percent. This is why it is advisable not to allow deflation to occur in the first place.
Ultimately, the objective of moderate price increases is to ensure that individual euro area countries whose inflation rate is somewhat lower than the euro area average do not drift into deflation.

How is inflation measured?

The staff of the Federal Statistical Office measure average consumption behaviour in Germany and use these data to define a basket of goods and services. They compare the price developments of this basket over time.
These baskets differ between euro area countries and the consumption habits of their population.
The staff of the Federal Statistical Office and the Statistical Offices of the Federal States measure the overall development of consumer prices in Germany. To this end, they continuously monitor the prices of a large basket of goods and services purchased on average by consumers in Germany. This includes many different kinds of food as well as petrol, furniture, package holidays, rent or insurance premiums. The contents of the basket are continuously adjusted to take into account altered consumption habits or new products. In total, the statisticians look at around 650 types of goods and record more than 300,000 individual prices within these categories of goods on a monthly basis.
From the abundance of data, the Federal Statistical Office then calculates each month what is referred to as the consumer price index (CPI), which summarises all prices relevant to consumers in one single figure. The year-on-year percentage change of this index is the inflation rate. For example, if the HICP is 1.5% higher than it was 12 months ago, this corresponds to an inflation rate of 1.5%. In all EU countries, the HICP is calculated based on binding standard accounting principles, although the basket of goods naturally varies from country to country, depending on spending behaviour. Each euro area country regularly reports its Harmonised Index of Consumer Prices to the European statistical office Eurostat. The official inflation rate for the euro area as a whole is then calculated on the basis of this. For Germany, the Federal Statistical Office also reports the consumer price index (CPI), which is calculated in accordance with national principles. The differences between inflation rates measured by the HICP and the CPI in individual months are usually not particularly significant.

Why is high inflation detrimental?

Recipients of a fixed income struggle to protect themselves against inflation; this holds especially true for those receiving social benefits.
To keep an economy healthy and growing, it is important that the value of money remains stable. Inflation impairs growth and prosperity in many ways.
It hinders the efficient use of resources: prices send out signals about market scarcity and surplus. In this way, they ensure that resources such as labour and capital are deployed where they are needed the most. If, for example, prices for microchips rise sharply, manufacturers know that microchips are scarce, meaning that demand is high. They will then consider expanding their production and recruiting new employees. Inflation hampers this signalling function, because only if prices are generally stable can enterprises and consumers definitively conclude that the goods in question are scarce if prices increase.
In addition, high inflation rates frequently imply more strongly fluctuating inflation rates. These fluctuations pose a risk for investors and thus make long-term investment more difficult.
In a progressive taxation system, rising prices create higher burdens without this having been preceded by an increase in economic performance. This may put a dampener on economic growth.
Unexpected and fluctuating inflation leads to an arbitrary redistribution of income and wealth. If the rise in inflation is unexpectedly high, the real value of debt falls. As a result, debtors, for example, are then relieved and creditors are debited. This can undermine confidence in property rights.
In most cases, inflation also results in social disruption. Socially disadvantaged members of the workforce have little bargaining power when it comes to remuneration for their labour. Households receiving social benefits are dependent on political decisions. Furthermore, socially disadvantaged households spend a larger share of their income on daily consumption, and therefore, relatively speaking, suffer more strongly from the effects of higher inflation rates. They do not have much of a buffer when prices rise steeply, and are obliged to limit their spending in real terms.
The potential repercussions of inflation show how important it is that the value of money remains stable. The independence of the central bank is a key prerequisite for maintaining price stability.

The ECB Governing Council has raised key interest rates. Why?

Together with the national central banks of the Eurosystem, the ECB has the task of ensuring stable prices. It has a range of instruments at its disposal for this purpose, in particular policy rates.
The ECB Governing Council raised them in July for the first time since 2011. In addition, it addressed the prospect of further interest rate increases going forward. This is because higher interest rates have a dampening effect on demand and therefore on price developments, too.
The ECB aims to achieve an inflation rate of 2% over the medium term. Negative and positive deviations from this target are considered to be equally undesirable.
In the euro area, the Eurosystem, i.e. the European Central Bank (ECB) and the national central banks of the Member States, are tasked with safeguarding price stability. As part of its monetary policy, the Eurosystem determines the cost at which commercial banks can borrow short-term money from central banks. In this way, it steers the short-term interest rates at which banks grant credit to other banks and indirectly influences the interest rates on bank loans to businesses and consumers. These interest rates decide whether a business deems an investment to be worthwhile. Furthermore, they determine the share of income consumers choose to save rather than spend. Adjustments to policy rates also influence economic agents’ expectations and the exchange rate of the currency. Via all these channels, monetary policy impacts on aggregate demand and, by extension, on consumer price inflation. To do something to counter the current high inflation, the ECB Governing Council raised the key interest rates in July for the first time since 2011. In addition, it addressed the prospect of further interest rate increases going forward. This is because higher interest rates have a dampening effect on demand and therefore on price developments, too.
The Governing Council considers that price stability is best maintained by aiming for a 2% inflation rate over the medium term. Negative and positive deviations from the medium-term inflation outlook are considered to be equally undesirable. One reason why the word “medium-term” is so important is that temporary deviations from the target do not necessarily require a monetary policy response. It is far more crucial for monetary policy that medium and long-term inflation expectations are firmly anchored at the target level of 2%. I

What is a wage-price spiral?

Reciprocal increases in wages and prices, which may be accompanied by higher inflation expectations
Spirals of this kind can entrench or even drive up inflation
Preventing them is the task of a stability-oriented monetary policy
Life in Germany has become more expensive. It is therefore understandable that workers and trade unions are fighting for higher wages to offset higher prices. This response to price changes is known as a “second-round effect”. However, excessive wage increases can cause inflation to become entrenched and, in the worst case, can even fuel inflation. This is because higher wages lead to rising production costs for firms. If wages grow faster than productivity, firms try to offset their higher costs by raising prices. The higher prices then tend to prompt trade unions to make additional wage demands, which again leads to price increases. This process is known as the wage-price spiral. It can build up momentum very rapidly if wage bargainers act pre-emptively to try and protect themselves from higher wages and prices. It is the task of a stability-oriented monetary policy to prevent this.