How Tit-for-Tat Inflation Can Make Everyone Poorer

High energy prices have led to dented real incomes for households and firms in the euro area. Negotiations between firms and workers are ongoing to determine how to allocate these losses. However, both sides trying to offset any actual income losses unilaterally could trigger successive wage and price increases, leading to a dangerous upward spiral that could ultimately make everyone poorer.

Rising Inflation and Shocks in the Euro Area

Inflation has been high in the euro area recently, primarily due to a surge in energy prices. This has led to households and firms losing real income. The situation has been exacerbated by supply chain problems driving up import prices. As a result, firms are now incentivized to raise prices to protect their profit margins, while workers want to adjust their wage claims to recoup actual wage losses due to higher prices.

Risk of an Upward Spiral

The “tit-for-tat” dynamic created by firms raising prices to maintain profit margins and workers adjusting their wage claims to recoup actual wage losses leads to a push-pull situation. Both effects drive up costs, and the feedback loop between higher profits, nominal wages, and prices creates a risk of an upward spiral. This feedback loop can push long-term inflation expectations away from the ECB’s 2% target, which must be avoided to keep inflation under control.

What Drives Inflation?

We can assess the contribution of wages and profits to domestic price pressures in the euro area based on the GDP deflator, which shows the prices of the gross value added produced in the region. The GDP deflator can be broken down into unit profits, labor costs, and taxes.

Domestic price pressures have increased enormously since the second half of 2021. In the fourth quarter of 2022, the GDP deflator’s year-on-year growth increased to 5.8%. This highlights the intense reactions of workers and firms to energy and input cost pressures and shows that the intention to offset actual income losses is driving higher inflation. The latest increases in the GDP deflator have been caused by both unit labor costs and unit profits, with the latter contributing more than half the domestic price pressures in that quarter.

Related Facts

• The euro area imports more than half of the energy it uses.
• High energy prices have been a driving factor in inflation.
• Supply chain problems have increased import prices, further exacerbating income losses.

Key Takeaway

Without a coordinated effort between firms and workers, tit-for-tat inflation can lead to an upward price spiral, ultimately pushing long-term inflation expectations away from the ECB’s target and making everyone poorer.

Conclusion

The solution to the issue of dented real incomes due to rising energy prices lies in a coordinated effort between firms and workers. However, unilateral attempts by either side to offset losses may lead to an upward spiral of wages and prices, leading to long-term inflation expectations deviating from the ECB’s target. Ultimately, this would only make everyone poorer.