 When asked to talk about the future, needless to say this is an intimidating task. There's hardly any topic more relevant for the conduct of monetary policy than the future of inflation dynamics. Policies matter for what the path of inflation is going to be. It's behind the inflation spikes we've seen through the summer, and are they here to stay? You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. Every year we hold the ECB forum on central banking. It's also known as Cintra, as a nod to the Portuguese hillside town where pre-pandemic editions took place. This year, policy makers and economists met virtually from across the globe to discuss climate change, employment and inequality, and what all of this means in a post-pandemic world. They also spoke about inflation. It's a hot topic at the moment, with prices rising at the fastest pace in 13 years. Today, I'll be taking you through some of the discussion highlights and unpacking them. We're recording this episode on Monday, 4th of October, 2021. I said yesterday that we're back from the brink, but not completely out of the woods. And that is certainly the good translation of what we have seen, which was a very unusual recession followed by a very unusual recovery. And we are in that process of recovery. It's a very unusual recovery because it is the steepest recovery we have seen in the Euro area since 1975. That was President Christine Lagarde in her opening speech at Cintra. She described the ongoing recovery, which is really like no other. What does that mean? That gave rise to an unprecedented slump in economic activity. As economies reopen, we're seeing an increase in inflation, and that's the rate at which prices go up over time. A preliminary report last week showed inflation jumped to 3.4% in September, and it's likely to keep rising in the coming months. This is not just happening in the Euro area, though, as Chief Economist of the IMF, Gita Gopinath, explained. Inflation is running high, both headline and core in the US as of now. But the expectation is that this will be transitory. In the US, it is transitory in the sense that it will come down, but of course it will stay at some elevated levels for a few more quarters. And by the end of 2022, it comes down to levels more in the normal ranges. Before we go into the recent inflation spikes, let's take a brief look at where we're coming from. Over the past 10 years, we've actually faced the opposite problem. We've seen persistently low inflation, so prices haven't actually gone up a lot. And that comes with its own challenges. Since the global financial crisis of 2008, inflation has averaged just 1.2% in the Euro area. Now if you're an avid follower of our podcast, you'll know that our price stability objective is 2%, so we've been quite a way off that mark. President Lagarde named three reasons for low inflation. Number one, looser labour markets, as new workers such as women and older people entered the market. Number two, slower wage growth because of globalisation and automation. And lastly, a reluctance to raise prices because of competition from e-commerce. So back to the inflation spikes and back to something else, Gita mentioned. The spikes are transitory, they're temporary, they're something we're seeing now and policy makers don't expect them to last. What we are seeing now is mostly a phase of temporary inflation linked to reopening. So why have prices been going up? Well, there are several reasons, many of which are linked to the reopening of the economy after the pandemic, as President Lagarde has just said. There are two main factors. One is pent up demand and another is what economists call the base effect. There is the pent up demand that has returned strongly for certain sectors, but also the supply side bottlenecks that are persisting. And I would say that they're persisting much longer than many of us expected at the start of this year. So the pandemic driven bottlenecks I think are an important factor weighing on the prospects including for inflation going forward. Let's tease out the issues with supply and demand that Gita Gopinath is talking about here. Thanks to support schemes during the pandemic, many people could return to their jobs once the worst was over. Similarly, firms and banks had enough help to weather the storm and emerge on the other side. Now of course, this is great news for the economy. GDP has seen the steepest recovery in the Euro area since 1975, so much so that we expect it to exceed its pre-pandemic level by the end of 2021. However, we've seen a huge rush on certain products, on electronics for example. And this is causing supply bottlenecks, which have only been made worse by things like COVID outbreaks in ports and shipping constraints. All of this is pushing up the price of these goods. These supply chain disruptions are costly and producers might put up their prices to cover them. This can also cause some of the inflation we're seeing at the moment. Now that's normal after a crisis and it usually only lasts a few months. It might last a little bit longer this time though, because as President Lagarde said, the pandemic has caused a recession like no other and a recovery that has few parallels in history. There's another big factor affecting the inflation spikes and that's something we call base effects. Inflation collapsed last year when lockdowns were imposed, which is creating strong base effects as activity recovers. Of total inflation in the euro area today is due to energy prices, which are making up the lost ground from 2020. Base effects from last year's German VAT rate cut and the unusual timing of sales periods are also playing a role. Put simply, inflation is so high now because it was so low last year. It's all got to do with how inflation is measured. In the euro area, we compare how prices change from one year to the next. Last year, inflation collapsed because of the pandemic. Since then, the recovery has taken hold and activity is resuming. So of course, if you measure prices today against the very low levels of last year, it will look like there has been a huge jump in inflation. We've seen this particularly clearly in two categories. First, in energy prices. Half of the total inflation in the euro area today is due to energy prices. Demand for energy plummeted during lockdowns. We simply didn't need as much of it. No one could travel and offices and shops were shut. Now as life slowly returns to normal, energy prices are making up the lost ground from 2020. The second place we're seeing this is Germany and it's due to something very specific. Last year, the government cut the sales tax, also known as VAT, to boost spending. Now, German VAT rates are being raised up again. And that's showing up in the inflation spikes we're seeing today. All this suggests that the spikes aren't permanent, that they're not here to stay. The pandemic has caused a recession like no other. And a recovery like no other that has few parallels in history. The inflation response reflects the exceptional circumstances we are in. We expect that those effects will ultimately pass. So what will come after the pandemic? President Lagarde mentioned three new trends that the pandemic has created. These three trends may impact inflation in the future, pushing prices further up or down. Let's look at the demand side of the economy first. Historically, core inflation in the euro area has mostly been driven by services inflation, which has contributed 1.1% points to the long-term average of 1.3% point. This is both because services have a higher weight in consumption and because goods inflation has been held down by global forces of automation, competition, globalization. Services inflation gives economists a good idea of how strong the economy is. The key question here is, will there be much more demand for services once we're out of the pandemic? So people have saved up a lot of money during lockdowns and we know from surveys that they aren't planning to spend these savings anytime soon. Of course this can change. They might be willing to spend more and also take more risk as we go out of the pandemic. We at the ECB expect that by the end of 2022, consumption will be 3% higher than before the pandemic and that would drive up service inflation and with that lead to higher prices. But there are also limits to how much services can be consumed. You probably won't get your hair cut twice just because you couldn't do it during the lockdown and we saw that even when restrictions were eased people still spent 15% less on services than before the pandemic. The second trend is related to changes on the supply side of the economy. The pandemic has delivered a major shock to global supply chains and domestic labour markets. It has significantly accelerated the process of digitalization according to one estimate by seven years in Europe and it may have distributional consequences that lead to changes in social contracts. In the long run some of these changes might dampen inflationary pressures. Digitalization is a particularly interesting one to look at here. We've all seen that the pandemic has massively sped up that process. President Lagarde goes on to explain one scenario that digitalization could trigger a second wave of globalization. With more and more services being available virtually it could become cheaper to produce and offer certain services potentially with fewer people involved and that could make these services cheaper pushing inflation down. On the other hand supply bottlenecks could lead to higher prices. With the lockdowns across the world many firms have struggled to get hold of the materials and products that they needed. Previous pandemics such as SARS showed that such bottlenecks can push firms to make changes to their supply chains and productions. This can make things more expensive. Let us now look at the third trend. We've looked at the demand side, the supply side. Let's look at what comes next which is probably the most important yet least explored at this point in time and that is the green transition. The shift towards a low carbon economy. The pandemic has given the green transition a boost. It could lead to an accelerated increase in auction prices in the EU emission trading system, the introduction of carbon prices covering a wider range of economic activities and the adoption of a carbon border adjustment mechanism all of which could have a direct inflationary impact. With ambitious transition policies being drawn up in Europe we need to better understand what these mean for prices, adds President Lagarde. One of the examples she gives is energy prices. Today 15% of our energy consumption is from renewable energies. Up from only 5% in the 90s. We need to get a better idea of how the green transition will affect inflation. So these were some of the topics at the 2021 ECB forum on central banking, the current spikes in inflation and how long the bottlenecks that are causing them will last and the longer term trends which can push inflation either higher or lower. Check out the show notes for further reading on this topic. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard please subscribe and leave us a review. We'd also love to hear from you so do share your feedback and ideas with us via social media. Until next time, thanks for listening.