Euro area inflation: From supply shock to wage shock?

Inflation has dropped sharply from the heights seen at the end of 2022 as negative supply shocks have reversed and domestic demand has been sluggish. Given that the disinflation on the back of lower energy prices and normalization of supply chains has mostly run its course, wage growth has now evolved into the main stumbling block for the ECB to reach its 2% inflation target. The crucial question for the ECB is consequently whether wages will moderate in the coming quarters such that inflation will decline to and stay at the ECB’s 2% target . An obvious complicat ion in answering this question is that inflation and wage growth are to a significant extent “co-determined”, meaning that inflation and inflation expectations determine wage growth, as much as wage growth is a driver of inflation. Following Bernanke and Blanchard (2023) , we model the co- evolution of inflation and wages as a function of energy and food price inflation, supply chain bottlenecks, labour market tightness and productivity growth. Assuming a “normalization” of all these exogenous drivers leads to a path for wages and inflation that is broadly consistent with the ECB’s 2% inflation target. However, what our simulations also show is th at any adverse shock to energy and food prices or supply chain pressure would lead again to a lasting upward deviation of inflation from the ECB’s target.