Diverging Inflation Dynamics: A Comparative Analysis of the Eurozone and the United States

Inflation in the Eurozone and the United States has been moving in different directions, with inflation in the Eurozone seeming more stubborn and harder to reduce. In spring 2023, core inflation (which leaves out energy and food) in the U.S. stayed at 5.5%. This was mostly due to how much housing rents (38% of the measure) contribute to inflation there. Rent increases of 8% year-on-year pushed inflation up, but this trend is expected to reverse because house prices are starting to drop. If you take out energy, food, and rents, U.S. inflation fell from almost 8% in early 2022 to 3.8% by April 2023. More drops are likely as growth slows, the job market softens, and wages rise less.

In contrast, inflation in the Eurozone (excluding energy and food) hit 7.3% in April 2023, much higher than in the U.S. This difference highlights deeper, structural reasons for inflation pressures in the Eurozone.

Key Differences Between U.S. and Eurozone Inflation

Three main factors explain why inflation behaves so differently in the U.S. and the Eurozone:

• Wage Growth: Wages are rising faster in the Eurozone, with a 5.5% increase expected in early 2023 compared to just over 4% in the U.S.
• Corporate Profit Margins: Since 2021, companies in the Eurozone have increased their profit margins, adding about 1.5 percentage points to inflation each year. On the other hand, U.S. corporate profit margins have gone down, which has helped lower inflation there.
• Monetary Policy Tightness: Europe's Central Bank (ECB) is more accommodating to policymakers than the Federal Reserve Bank. It reported -5.75%, against inflation rates like-5.5% for rents. Its repo rate was 4.75% against a core inflation rate of 7.3%. This gap of 300 basis points in inflation-adjusted rates has allowed inflation to stay higher in the Eurozone.

These factors mean the Eurozone is more likely to have ongoing inflation compared to the U.S.

Structural Causes of Eurozone Inflation

The Eurozone's inflation problems come from deeper issues related to production constraints identified by European businesses.

• Underinvestment: After the 2008–2009 financial crisis, business investment in the Eurozone dropped and stayed low until 2018. In fact, it was worse in 2019 compared to that in 2014, only to worsen again, leaving companies with equipment shortfalls.
• Labor market strains: However the number of job vacancies increases again compared to unemployment. In 2016, the quotient stood at 0,15; now it stands at 0,50. This labor scarcity makes it difficult for companies to catch up with the ever-increasing demand.

The Way Forward: A Continuing Inflation Environment

Sometime around 2017, Europe transitioned from too-little-demand to too-much-demand inflation thanks to shortages in raw materials and labor. Thus, inflation will remain for a while, which is much longer than usual. Unless demand falls once again, substantial decreases are unlikely; yet for the near future such an event appears hard to imagine. The problem with that is this: there are too many "deadweight" effects like stagnant productivity and a decrease in working-age populations in the landscape to address all of these issues.

Economic growth in the Eurozone is expected to stay low. Growth of 0.8% in 2023 and 1.5% in 2024 will likely exceed the region’s potential output, which will add more pressure to inflation. Predictions from the ECB and financial markets, aiming for inflation just above 2% by late 2024, may be overly optimistic given these challenges.

Conclusion: Inflation Beyond Expectations

A constant high inflation is very probable for a long time in the Eurozone because of problems that emerge from underinvestment, labor deficiencies, and loose monetary policy. These need a major change in policy so as to address labor shortages, uplift investments, and boost productivity in the economy. Without doing so, the inflation in the Eurozone will remain at a higher state vis-a-vis the U.S., complicating strain due to economic stability and policymaking for years to come.