Why Inflation Is Diverging in the Eurozone - Energy is Key

25 November 2022 15:18

Over the past 18 months, the Eurozone has witnessed the sharpest rise in inflation since its inception. But the inflation wave also stands out from a longer, post-World War II perspective. What has received less attention, though, is the huge variation in inflation rates across member states.

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Unprecedented Inflation Variation

Over the past 18 months, the Eurozone has witnessed the sharpest rise in inflation since its inception. But the inflation wave also stands out from a longer, post-World War II perspective. What has received less attention, though, is the huge variation in inflation rates across member states.

Not only have the (cross-sectional) differences in inflation rates (according to the harmonized index of consumer prices, or HICP) risen sharply, but also the positive correlation with inflation trends is high (see Figures 1 and 2).

Figure 1: Huge inflation shock with unprecedented inflation variation between member states, 2001-2022

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Source: Macrobond, RaboResearch 2022

Figure 2: Headline inflation rates, Sep 2022

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Source: Macrobond, RaboResearch 2022

A similar situation was seen in the years prior to the 2008 Global Financial Crisis, and in its aftermath, albeit with both inflation and variation moving down. Since then, that correlation has largely broken down – until now.

We argue that these inflation differentials can actually tell us something about the nature of inflation and the impact of government policy interventions. We believe, therefore, that these differences provide some hints regarding the future development of inflation.

In the first section we look at the variation in inflation compared to the Eurozone average from several angles. We zoom in on energy, given that it is by far the most important contributor to recent inflation. In the second section we discuss recent policy measures and announcements and their impact on inflation in the six biggest member states (which account for some 86% of Eurozone HICP).

Energy Comes First

The variation in inflation rates between the member states is currently extreme. In this section we show that this is first and foremost driven by large differences in the pass-through of (wholesale) energy costs, the share of energy in consumer spending, government interventions, and, to a lesser extent, the indirect ‘energy content’ of inflation. Figures 3 and 4 break down the inflation differential between a member states and the Eurozone through various lenses. Figures 5 and 6 zoom in on the contribution of gas and electricity costs, and food prices, to the headline inflation differential with the Eurozone. We have taken the 12-month sum of monthly changes in inflation up until September as the basis for this analysis.

Figure 3 splits the difference between individual countries’ inflation rates and the Eurozone average into:

A price effect, which gauges whether prices of specific items have risen more or less than the Eurozone average. A composition effect, where a higher share means a bigger contribution to the overall inflation rate. An indirect tax effect.

We estimate the composition effect by assuming that all countries experienced the same per-item price increases as the Eurozone average. To estimate the price effect, we assume that the composition of each of the national HICP baskets is the same as the Eurozone's.[1]

The most salient finding here is that the relatively high inflation rate in Eastern European member states can be explained by both relatively large price increases in energy and food as well as those items’ relatively large share in the consumer basket.

A large negative contribution from taxes in the Netherlands (due to tax cuts on the energy bill and a reduction of fuel excise duties) and a large positive tax effect in Austria (due to the ending of a temporary low-tax regime for restaurants) also stand out.

Figure 4 breaks the difference between the inflation rate of a member states and the aggregate Eurozone inflation into the four key items in the consumption basket: gas and electricity, liquid fuel, food and drink, and non-energy, non-food items (i.e. core inflation). It shows that price increases for electricity and gas, as well as food and drink, have been the key drivers of inflation differentials. Core inflation differentials play second fiddle, not only because differentials between countries are smaller, but also because they are dwarfed by the energy effect.

Comparatively speaking, liquid fuels prices are not a very distinguishing factor between countries (except for Luxemburg). This partly reflects the lower share of liquid fuels in the consumption basket but it also highlights the role and influence of the gas and electricity distribution system: whereas liquid fuels can be transported relatively easily, demand-supply imbalances in gas and electricity often need to be resolved at the local level.

1. Our method, which resembles Kirchner contributions (see p. 183 of the Eurostat manual), does give small statistical discrepancies, but it does help explain whether the inflation differential is driven by a high share of a certain item or by a higher inflation rate than in the rest of the Eurozone.

Figure 3: Breakdown of inflation differential with the Eurozone by price, share, and tax effect, Sep 2022

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Source: Macrobond, RaboResearch 2022

Figure 4: Breakdown of inflation differential with the Eurozone by major item in the basket, Sep 2022

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Source: Macrobond, RaboResearch 2022

France stands out as the country with the lowest inflation over the past 12 months. This is especially because of smaller increases in electricity and gas prices, which is due to government intervention, as we will explain below. By contrast, the big contribution of electricity and gas prices to inflation makes the Netherlands stand out. However, this is largely due to a different methodology for measuring these prices: The Dutch statistics office assumes that all households sign a new contract with energy suppliers each month. It has acknowledged that a different methodology – which it is currently developing – would produce a significantly lower inflation rate.[2] The Netherlands, meanwhile, also shows the biggest cut in indirect taxes for this energy item in the past 12 months.

2. The Dutch statistics bureau recently noted that the inflation rate based on the national CPI would not have been 12% YOY in August, but rather between 7.5% and 9.6% if a new method had been used: so, 2.4 to 4.5 percentage points lower. This would explain a good chunk of the inflation differential between the Netherlands and the Eurozone average. It also means that the Eurozone average could be revised down by some 0.2 to 0.3 percentage points should that methodology be implemented.

Figure 5: Gas and electricity is the main source of inflation differences, Sep 2022

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Note: This figure shows the contribution of electricity and gas to the headline inflation differential with the Eurozone Source: Macrobond, RaboResearch 2022

Figure 6: Food and drink also plays a decisive role in inflation differentials, Sep 2022

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Note: This figure shows the contribution of food and drink to the headline inflation differential with the Eurozone Source: Macrobond, RaboResearch 2022

Indirect Energy Effects May Be Considerable

Differences in the contribution of core inflation to headline inflation differentials can largely be explained by ‘price effects,’ as we would expect. In other words, the most important reason for the contribution of core inflation to be larger in some countries than in others is because core inflation is much higher there, not because the share of core components in the overall index is larger. There are several drivers behind the core inflation differentials, such as different wage cost developments and indirect energy effects.

Generally speaking, core inflation is higher in countries with higher growth in wage costs (see Figure 7). Moreover, Figure 8 suggests that real wage costs (hourly labor costs adjusted for core inflation) are falling less sharply in countries with low unemployment rates or are even rising on a year-on-year basis in some countries, such as Germany, Austria, and Belgium. As such, the ‘cross sectional’ Phillips curve relationship between labor market tightness and real wages seems to remain intact. That said, this outcome may be sensitive to the sample of countries chosen. Nevertheless, differences in core inflation between member states can be partly explained by higher wage growth and/or differences in labor market tightness.

Figure 7: Positive correlation between wage costs and core inflation, Sep 2022

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Note: blue dots are individual EA-19 Member States Source: Macrobond, RaboResearch 2022

Figure 8: Tighter labor market means stronger growth in real wage costs, Aug and 2022Q2

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Note: orange dots are individual EA-19 Member States Source: Macrobond, RaboResearch 2022

But wages don’t tell the full story when it comes to core inflation, especially over the last 12 to 18 months. There is also a role for energy here. The price of energy has a direct impact on inflation. But energy prices have risen to such an extent that they have also become visible in other goods and services that are usually not associated with energy: in other words, non-energy inflation. The local bakery has raised its prices not only because the price of grains and other inputs have increased, but also because its energy bill has exploded. Package delivery services are facing higher fuel bills. And so are many other businesses and industries.

Normally, these effects are immaterial or are largely absorbed by profit margins. But when energy costs rise by over 40% – as they have done over the past 12 months – even goods and services that require only a relatively small amount of energy to produce suddenly have to be priced higher in order for sellers not to take too severe of a cut to their margins. Simply put: Even if energy accounts for just 5% of production costs, when energy prices rise 40%, that is still a 2% increase in total costs on top of other costs.

In order to gauge this effect on non-energy prices, we ran a series of regressions of HICP data on energy prices, allowing for lagged effects of up to nine months and controlling for labor costs and non-energy commodity prices. We did this for all 19 member states as well as the Eurozone average, both on the two-digit HICP categories (11 categories excluding energy) and three-digit level (approximately 46 categories, depending on the member state). A more detailed description can be found in Appendix A at the end of this article.

The major takeaway: a very sizeable part of the rise in non-energy inflation can be attributed to indirect energy costs. For September, we estimate this at around 3.3 percentage points. This effect is most visible in food. Food prices rose by 11.8% YOY in September, but corrected for indirect energy effects, the rise would have been a much more ‘normal’ 4.1% YOY. Core inflation (excluding energy and food) stood at 4.8% YOY in September, but would have been 1.7 percentage points lower without indirect energy effects. The pass-through effects of energy prices to other prices are very strong in some of the Eastern European states (Slovakia, Latvia, and Estonia in particular) as well as in Portugal, Austria, Luxembourg, and Germany. They are remarkably modest in France, Ireland, and Belgium. As such, these indirect energy effects also explain some part of the cross-country variation in inflation, furthering highlighting the big role of energy (see Figure 10).

Figure 9: Rise in HICP component due to indirect energy costs, Sep 2022

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Source: RaboResearch 2022

Figure 10: Estimated impact of indirect energy effects by member state, Sep 2022

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Note: Core inflation is just for comparison purposes. The dark blue bars are not ‘contributions’ to core inflation. Source: RaboResearch 2022

Zooming In on the Six Biggest Member States

Another factor driving inflation differentials is government support. Across the currency block, governments are trying to help households and businesses cope with the massive increase in prices. This section focuses on the six largest member states[3] and their economic support measures that are likely to have had a direct impact on inflation in the 12 months leading up to September. In a forthcoming article we will dive deeper into the broad range of support measures announced to offer a comprehensive view of the impact of government support on the economy, now and in the future.

Although there are some similarities in the measures taken, governments seem to have different views on how to best tackle the cost of living crisis – be it out of conviction, complacency, or limited fiscal space. For example, many have chosen to cut energy taxes and excise duties; some have lowered indirect taxes, handed out lump sum payments, or implemented/expanded social tariffs for less-endowed households; still others have put in place outright caps on energy prices or on the increase thereof. Some measures are directly targeted at keeping a lid on prices, while others support household incomes.

Figure 11 categorizes government support policies targeted at households into measures that initially lower inflation or raise household incomes. We say initially, because paradoxically, government support could backfire. For example, fiscal measures that help preserve demand for something with limited supply, such as gas, only further inflate the prices of such products – and the prices of downstream goods produced with those products. Companies and households not protected against price increases by price caps could therefore be exposed to a new bout of price increases.

3. Germany, France, Italy, Spain, The Netherlands, Belgium

Figure 11: Support measures can directly influence prices or raise household disposable income

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Source: RaboResearch 2022

Ranking the Member States

We have ranked the six countries by the direct impact government measures have had on inflation so far (see Figure 12 and Appendix B for a more detailed overview of policy measures to limit price increases). Measures to clamp down on electricity and fuel price inflation have had the largest impact on headline inflation figures. Between the two, measures aimed at tempering electricity prices have clearly had a larger impact in most countries.

The French government took the most far-reaching action on electricity and gas prices by not only reducing the tax rate on electricity, as most other countries did, but by also imposing a cap on the price increase of regulated electricity tariffs (4% in 2022, to be increased to 15% in 2023) and gas bills. These measures cover about 70% of households. According to the French statistics office, INSEE, inflation would have been 3.1 percentage points higher between Q2 2021 and Q2 2022 without the price caps. Spain comes in second. Since July last year the government has cut different kinds of taxes on electricity (although these cuts are no longer visible in our inflation differential data due to the way inflation is calculated). Since Q4 2021 the Spanish government has also capped the quarterly increase of the regulated gas tariff to 4% to 5% (covering about 1.5m out of the 8m domestic gas consumers) as well as increased the size and scope of the social electricity bonus – a discount on the electricity price for vulnerable households with a regulated tariff, subsidized by the government. On top of these tax cuts, since mid-June 2022, Spain has capped the price of gas used for electricity generation.[4] This has benefited just under half of all households.[5] The cap will remain in place until May next year. According to Banco de España, these measures combined lowered headline year-on-year inflation by slightly over 2 percentage points in August.[6] To date, Germany seems to have done the least to directly lower electricity and gas prices for households. So far, Germany has focused on supporting household income (and on helping businesses to cope with high prices). From next year, it also plans to subsidize a share of gas and electricity consumption, as does the Netherlands.[7]

To temper the price increase of motor fuels, Germany, Italy, the Netherlands, and Belgium have cut excise duties over the past year by various degrees and duration. France and Spain chose to discount fuel prices through gas stations. Looking at duration and size, Italy subsidized fuel prices the most in the 12 months leading up to September, while Germany, again, did the least, because its cuts had a shorter duration.

Finally, governments have also embarked on other forms of price interventions. Germany, Spain, and Italy, for example, subsidized public transportation for several months, while Spain and France capped rent increases. These measures can have a significant impact on the purchasing power of individual households. Moreover, promoting public transport could lower the price of car fuels via lowering demand. Yet, the direct impact of these measures on headline inflation has actually been fairly small, which is why we have excluded it from the ranking exercise in Figure 12.

4. In September the government announced an extension of the cap to cover gas-fuelled power plants linked to heavy industry.

5. Power plants will receive the difference between the market price for natural gas (i.e. the price on the Iberian Gas Market MIBGAS) and the reference price set by the government. The costs are funded by additional congestion income (due to extra exports to France due to the fall in electricity prices) and Spanish consumers benefiting from the measure. This prevents any impact on the public balance, but also limits the impact on inflation. Because of how electricity market price setting works, a share of Spanish consumers will benefit mostly because they end up paying a lower cost for electricity generated with, for example, renewables. In a recent note, the Bank of Spain stated that in August the cap had subtracted 1 percentage point from the year-over-year headline inflation figure.

6. The measures introduced in July 2021 no longer had an impact on August’s inflation figure. The impact the cap on the price of gas used for electricity production has on inflation greatly depends on the difference between the capped price and market prices. Hence, due to the fall in the market price, the impact of the cap was much lower in October than in August, for example.

7. Our Dutch economics colleagues have estimated that these planned measures will reduce inflation by 2.9 percentage points next year (in a Dutch language note, here).

Figure 12: France has been most effective in keeping a lid on inflation in the 12 months to September 2022

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Note: Ranking from 1 to 6, with the country having implemented the most (effective) measures to limit price rises within a category receiving a 1. This is not to say that this country’s policy is preferred from a macro perspective. Broad-scale support and market invention have possible large, negative side effects in an environment hit by a large negative supply side shock, as we explain in the text. * This figure is expected to come down substantially once the Dutch statistics office has implemented its revised calculation method for energy inflation. Source: RaboResearch 2022

Among the six largest member states, energy prices – and therefore headline inflation – have increased the least in France. The main reason is that the government has effectively capped the allowed increase in electricity prices. At first instance, the electricity provider EDF had to absorb the difference between wholesale and retail prices. Yet through full nationalization of the company, the French government is paying the bill.

The measures described in this section do not paint the full picture of government support. We have merely discussed the measures that have had a direct downward impact on consumer price inflation so far, to help explain existing inflation differentials within the Eurozone. A forthcoming article will analyse the broad set of government support measures – including those that have focused on propping up households’ disposable income and support to businesses – and their impact on both short- and long-term inflation and several other variables.

As discussed, although possibly helpful in the short term, widescale government support could end up pushing inflation higher while worsening public finances. Moreover, interventions to keep energy price rises in check run the risk of creating actual energy shortages, as they hamper the price incentive to cut back on demand for energy in an environment with reduced supply.

Conclusions and Implications

A cross-sectional analysis of Eurozone inflation data further underscores the importance of energy in the current high rates of inflation and differences in the inflation observed in individual countries. Higher energy costs have left their mark on inflation – both directly and indirectly. That said, recent government intervention, in the form of tax cuts and other measures to reduce prices, should not be underestimated. Most notably in France these measures have been significant and largely effective at containing inflation.

This analysis also identifies a number of key trends to watch in the coming months. First of all, should wholesale energy prices stabilize, we are likely to see bigger drops in inflation in countries where inflation also rose more sharply and quite quickly. To some extent this may also gradually filter through to a slowdown in core inflation, once the ‘indirect energy effects’ fizzle out. So some convergence is to be expected.

Still, our calculations indicate that around 0.9 percentage points of additional upward pressure on inflation from energy pass-through effects remain in the pipeline for the next 12 months (with the majority of that falling before April 2023). Moreover, Rabobank’s baseline scenario is for wholesale energy prices to veer back up as the European winter sets in. So both factors could make the convergence process described above rather slow.

Another key takeaway is that government policies will probably continue to contribute to inflation variation, unless member states were to opt for a harmonized approach (which we believe is quite unlikely). While we show that price and tax interventions can be quite successful in holding back inflation, there may well be a price to pay in the medium term if energy consumption does not fall sufficiently. The risk of a spiral of higher-than-expected energy cost inflation fueled by further government interventions – as well as the risk of actual energy shortages – is something that cannot be entirely dismissed. (We will address this topic in a forthcoming article.) Some first cross-country plots show that, so far, demand for gas has dropped amid increased prices, while demand for fuel, and especially electricity, has proven rather inelastic -due to multiple reasons. Important, in our opinion, is that measures that put a lid on gas prices could paralyze price incentives to cut back demand and, in turn, inflate market gas prices.

Last but not least, the big differences in inflation rates across countries raise serious problems for monetary policy as the European Central Bank’s one-size policy fits all even less than in ‘normal’ times. With inflation variation likely to remain high in the year ahead, this could further distort mechanisms like inflation expectations and wage formation.

Appendix A: Estimating the Indirect Impact of Higher Energy Costs on Inflation

Our goal here is to get an idea of the indirect effect from energy prices on non-energy components in the HICP. The data we used were: the overall and lower level (two-digit and three-digit) HICP index numbers and corresponding weights for each region (20, including the Eurozone average), the aggregate HICP energy index of that particular region, an aggregate index of hourly wage costs (interpolated to monthly figures) for each region, and the HWWA commodity price index, excluding energy (same for all regions).

The Model Used[8]

All indices were transformed to ‘quarterly’ log changes:

Inflation Formule 1(1)

Then, for each lower level index except the index concerning Energy (Housing, Water, Electricity, Gas & Other Fuels), we estimate a simple OLS model in which the delta index is the dependent variable. The independent variables are: the delta energy index and 3 lags, the delta commodity index and 3 lags, 3 lags of the delta labour costs index, and monthly seasonal dummies (Eq. 2)

Infl Form 2(2)

Figure 15 provides an example of the estimation results.

After estimation (up until August 2021), we simulate each HICP sub-index holding energy prices constant while adjusting all other factors. We only do this when the joint coefficients on the energy variable are significant at the 10% level (using an F-test). The difference with the actual outcomes then gives us an estimate of the combined effect of lagged and actual responses to the increase in energy costs. Using the predicted lower level price indices, we generate the predicted overall HICP using the Laspeyres index aggregation method and chain linking. See the

The gap between the two indices, as in the example below, gives an indication of the cumulative impact of indirect energy effects over the past 12 months. For the Eurozone, summing all individual member states’ results, this is around 3.3 percentage points. (When applied to the region’s aggregate HICP, this is around 3.8 percentage points, because the energy pass-through effect is rejected in fewer cases.)

8. With thanks to Revo Loonen for support in modeling and programming.

Figure 13: Indirect energy effects: holding energy prices constant after Aug 2021, Eurozone total

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Source: RaboResearch 2022

Figure 14: Breakdown of Eurozone inflation rate into contributions, Sep 2022

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Source: RaboResearch 2022

To put this in perspective, Figure 14 breaks down the overall inflation rate for September into contributions of direct and indirect energy effects, food (excluding indirect energy), and other effects. So nearly 70% of the inflation rate in September was due to energy.

Figure 15 is an example of an estimate for the Eurozone aggregate HICP index for food and non-alcoholic beverages. As this table shows, indirect energy effects are significant for the current quarter and lagged effects are also quite significant, notably the first and second quarter lag.This lagged response is particularly visible in food and non-alcoholic beverage prices (as shown here), hotels and restaurants, and less so in some other categories, such as transport, which generally show a quicker pass-through. However, our estimates also point at continued upward pressures in non-energy inflation in the coming months even when energy prices themselves have already turned the corner.

Figure 15: Sample estimation results for Eurozone HICP – Food and non-alcoholic beverages

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Source: RaboResearch 2022

Appendix B: Overview of Measures To Temper Inflation

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