How inflation reached all-time highs in two years

The onset of the COVID-19 pandemic and the lockdowns depressed supply of and demand for goods and services (phase 1). Figure 1 shows that this led to a sharp fall in gross domestic product and lower inflation. In phase 2, demand recovered on the back of the partial reopening of the economy and government support for businesses. At the same time, supply lagged behind due to various factors, including shipping containers being in the wrong places and semiconductors and labour being in short supply. The combination of improving demand and lagging supply caused GDP to rebound to near-pre-pandemic levels, but with higher inflation.

In the third phase, a combination of disruptions in the supply of goods and services and further increases in demand caused prices to go up even further. Supply in the European economy in particular suffered from a sharp rise in energy prices, especially gas prices. This rise already started in autumn 2021, ahead of the Russian invasion of Ukraine, and intensified after the invasion of 24 February 2022. Producers passed on higher production costs to their customers to maintain their profit margins. In addition, more and more people started working more hours and saving less, leading to strong growth in consumption. The tight labour market hampered the expansion of supply, while prices continued to rise.

The impact of supply and demand shocks on inflation

Using an econometric model, we can more accurately distinguish the impacts which supply and demand have on inflation. In the economy, a demand shock means that consumers and businesses want to buy more or less, while a supply shock means that producers want to supply more or less. Positive demand shocks differ from positive supply shocks in that they lead to more output with higher inflation, while positive supply shocks lead to more output with lower inflation. Because energy prices play an important role, we also identify a separate energy supply shock.

Figure 2 shows the model's estimated contribution of demand, supply and energy shocks to harmonised inflation (including energy and food). In the first stage, we see a combination of negative demand shocks depressing inflation and negative supply shocks pushing up inflation. On balance, demand shocks dominate, and inflation falls. As the economy reopens in the second phase, supply partially recovers (creating lower inflationary pressures) and demand rises sharply. At the end of this phase, higher energy prices due to limited energy supply also contribute to higher inflation. In the third phase, energy prices rise further due to energy supply constraints, while general supply constraints and strong demand also contribute to higher inflation.

Figure 2 Contributions of demand, supply and energy shocks to inflation in phases 1, 2 and 3

The model analysis shows that high inflation is not solely due to higher energy prices and supply constraints. High inflation in the euro area began with demand picking up due to the reopening of the economy, combined with lagging supply in 2021. Then, from summer 2021, rising commodity prices and the war in Ukraine exacerbated supply problems, and businesses passed on their higher costs to consumers. Our analysis shows that this was possible because demand picked up strongly throughout the post-pandemic reopening period.

Ultimately, high inflation is a matter of supply and demand. The increased role of demand factors behind high inflation increases the need to slow these down through monetary policy. In response to these developments, the ECB has accelerated the unwinding of its unconventional policy, raising policy rates in unprecedentedly large steps. The ECB will also continue to raise rates for the foreseeable future, until they reach a level high enough to bring inflation back to target.