Inflation and the Toothpaste Problem – Economy

The inflation in Germany is going down slightly, but that’s no consolation to anyone. In March, the inflation rate was still 7.4 percent, in February it was 8.7 percent. But core inflation is solidifying and even growing, only the pace of inflation is decelerating. Such price jumps have not happened since the 1980s. Food, of all things, is costing more and more. It is therefore natural that trade unions demand significantly higher wages for their members.

The currency watchdogs at the European Central Bank warn: wages must not rise too much, otherwise there is a risk of a dangerous wage-price spiral. This occurs when employers add the cost of higher wages to their product prices – further fueling inflation and leading to renewed wage demands. But it’s not that far at the moment. In addition, economists have calculated that employees in the monetary union have lost around five percent of their standard of living since 2021. That’s why central bankers’ fears are echoed by workforces who, with good reason, no longer want to be dumped.

The employees’ lack of understanding also applies to employers, who have always preached wage restraint: sometimes with the argument of remaining competitive, sometimes to save the location and jobs. That doesn’t work anymore. Many people have become poorer, they can afford less than a year ago because of the high prices. High inflation always has distributional consequences. Rich households own stocks and real estate, they easily absorb higher prices. Low-income households have little savings and now have to pay large bills to support themselves. Especially in sectors where there is little pay and there is a shortage of staff, people should finally fight for a reasonable wage. The machinists at the ECB have to endure that. Likewise, the fact that corporate profit margins are now also a driver of inflation. Many companies have raised their prices in recent months more than would have been necessary to compensate for the increased costs.

The ECB has only one tool to curb inflation: to further increase interest rates. As a reminder: in June last year the key interest rate was zero percent – in the meantime it has been raised to 3.5 percent in quick succession. Experience teaches that interest rate hikes often only take full effect after a delay of twelve months or more. In the meantime, however, the loans have already become more expensive. This, the central bank expects, will reduce corporate investment and consumer demand in the medium term, bringing inflation back to the target of two percent. However, in its own forecasts, the ECB assumes that it will take until 2024 for that to happen.

Confidence in the ECB has been damaged

The ruthless rate hikes by the ECB and the US Federal Reserve have also left their mark on the financial sector. The bankruptcy of some US banks and the collapse of Credit Suisse were solely due to the misconduct of the responsible managers – but the rapid interest rate hike by the central bank acts like a stress test for the banking sector because the bonds on the balance sheet have lost value as a result. If you will, the ECB and the Federal Reserve have made the weak lenders visible in the system. The fear of a Lehman 2 crisis is omnipresent, even if those responsible in politics and supervision assure that the banking sector is safe.

The fight against inflation, so it will take a few more years. Confidence in the central bank, which has pursued a zero interest rate policy for many years, has been damaged. Looking back, it is hard to imagine that the ECB justified its loose monetary policy by saying that inflation was “too low”. Now it’s the other way around, and the quip of former Bundesbank President Karl Otto Pöhl applies: “Inflation is like toothpaste. Once it’s out of the tube, it’s difficult to get it back in.”