The saying goes that better the devil you know than the devil you don’t, but perhaps inflation is a special case. An old acquaintance of economists, it did not present figures like those of 2022 since the beginning of the 1980s. In other words, up until 2021 around 45% of the European population had never lived with such high inflation, and just 30% had seen it in adulthood. In fact, in the last decade inflation gave cause for concern due to its weakness. However, following the pandemic and the invasion of Ukraine, inflation has quickly made up for the lost ground: whereas in late 2019 the euro area price index (HICP) was 7% lower than it should have been based on the target inflation of 2%,1 the sharp rally in prices since then has caused the HICP to virtually close this gap entirely by the end of 2022. What will happen in 2023?

The forces that triggered inflation to rise are global, somewhat unpredictable and exogenous. Above all, the pandemic caused significant imbalances between supply and demand by generating disruptions in global supply chains, blocking the consumption of services and redirecting much of the demand towards goods. Thus, bottlenecks emerged and inflation began to pick up, driven by goods, a rise in food prices and a rebound effect in energy prices (which had initially plummeted with the outbreak of the pandemic). Later, the lifting of restrictions also led to higher prices in services, as their activity normalised.

The mismatches between supply and demand that were caused by the pandemic ought to have a temporary effect on inflation and, in the absence of second-round effects, dissipate as economies normalise. In fact, the bottlenecks have been gradually clearing and, according to various indicators, since the autumn of 2022 they have been relatively limited and will help to curb inflation in 2023, although it is difficult to specify at what speed (transmission between bottlenecks and consumer prices occurred rapidly in 2021, but the historical evidence suggests that there may be lags of up to a year).2

Before this normalisation could materialise, the invasion of Ukraine added more fuel to inflation, exerting unprecedented pressure on energy prices and accentuating the rise in food prices.3 The price movements have been so abrupt (energy surged by over 40% year-on-year in the major advanced economies) that, through its pressure on production costs, the rise in energy prices has passed-through to many components of the consumer index: for instance, in the euro area it is estimated that the «energy-sensitive» components have added more than 2 pps to the inflation of services and around 3 pps to that of goods (approximately 50% of the observed inflation in both cases).4

All in all, the virulence of 2022 will, almost mechanically, have a downward effect on 2023. On the one hand, it should be taken into account that in 2022 as a whole, oil and gas – two of the major determinants of energy prices – surged by 60% (Brent) and 180% (TTF). A repeat of these figures in 2023 would result in extreme prices: oil at 130 dollars and gas at €320/MWh. But the dynamics of recent months have been the opposite: prices have stabilised and the forecasts (both those of analysts and market futures) suggest they will remain below those of 2022. Thus, in the absence of extreme scenarios, the significant, direct and positive contribution from energy should be rapidly diluted (see first chart).5 On the other hand, food is being affected by second-round effects (the rise in the price of food itself, energy and other inputs) and the projections do not point to a moderation until mid-to-late 2023.6

Finally, both the pandemic and the Russian invasion triggered the implementation of fiscal support measures to cushion the impact of the crises on household incomes. During the pandemic, the measures were particularly substantial in the US, and it is estimated that they contributed significantly to the rise in inflation.7 In Europe, meanwhile, the support measures in response to the energy crisis stand out: it is estimated that they slowed inflation by just over 1 pp in 2022 and that they will continue to deduct 0.5 pps in 2023 (consequently, their withdrawal in 2024 will likely push up prices due to a base effect).8

This year, in addition, the central banks will have their sights set on one of the main determinants of inflation in the medium term: wages. In theory, when wage rises outpace productivity growth, this generates inflation because of the higher costs that companies must bear. Rapid wage rises also stimulate the aggregate demand for goods and services, which in turn tends to put further pressure on prices. The data for 2022 have shown us that wages in the US have registered rapid growth, rising by over 5% year-on-year, while in the euro area these rates have not been much higher than the historical average (2.4%).

While it may still be too early to tell, in the US a slight slowdown in wages has already begun, so it appears that second-round effects ought not be a problem in 2023. Wage growth in the euro area had a very low starting point, but it is gradually rising. Indeed, it is plausible that pressures in the labour market to minimise workers’ loss of purchasing power could lead to higher than usual wage rises in 2023. To quantify the impact that wages could have on inflation in the coming quarters, we identified the components of the core consumer basket that have historically been sensitive to wage increases: 30% in the euro area and over 50% in the US.9

This figure provides a measure of the risk of second-round effects. In other words, if wage growth becomes more dynamic in the euro area, we know that 30% of the core consumer basket will tend to increase as well. However, there are several arguments that qualify this possible risk. The first is that there are still no significant wage pressures in the euro area. In fact, wages are growing well below inflation and the signs of acceleration are contained. The second is that if, in this illustrative exercise, we allow the components to switch between being sensitive and non-sensitive over time,10 we see how the relative weight of the sensitive components has decreased in the euro area since the outbreak of the pandemic (see third chart). The third argument is that in the US, an economy where wages have already accelerated sharply and where the structure of the consumer basket of goods is somewhat more susceptible to second-round effects, the contribution of the components of core inflation that are sensitive to wage rises has remained at around the historical average.11 In fact, in the US the main component that is driving up core inflation, and which is sensitive to wages, is shelter which accounts for more than 40% of the core index and is rising at a year-on-year rate of 7%. The inflation of this component is expected to remain high in the first half of 2023 due to the inertia it usually shows, although it could begin to moderate in the second half of the year.