Rising energy prices: 7.9 percent: What does the record inflation in May mean?

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    In May, the inflation rate was 7.9 percent, the highest since the winter of 1973. Why is that? Can we still take countermeasures? Answers to the most important questions.

    For the third time in a row, the inflation rate in Germany is over seven percent. The Ukraine war, the end of most corona restrictions and global supply chain problems caused the highest value since winter 1973.

    In May, consumer prices were 7.9 percent higher than in the previous year, the Federal Statistical Office announced on Monday. Economists had only expected 7.6 percent, which was also reflected in the stock market. After the announcement, the leading index Dax gave up half of its daily gains and was trading at 14,590 points in the afternoon.

    Are the concerns justified – what does the 7.9 percent mean? Five questions and answers.

    What are the reasons for the increase?

    First of all: The increase in May is not really surprising, even if economists had not expected it to be so dynamic. This was primarily due to higher energy prices, which rose by 38 percent in May. This was also reflected in higher producer prices – the selling prices of manufacturers at all stages of production. These increased by 33.5 percent in May, and thus stronger than ever.

    The increases are also noticeable in consumer-related services, such as in gastronomy. “We are seeing strong inflationary processes, especially in sectors that are now celebrating the end of the corona restrictions,” ZEW economist Friedrich Heinemann told Capital. Here, too, increased costs at upstream levels play an important role. Wholesale prices alone have risen by 26 percent, which restaurateurs are now passing on to customers.

    Why have economists so clearly misjudged?

    In recent years, economists have mostly been correct in their forecasts or very close to the actual result. A difference of 0.3 percentage points is now a striking amount – but only as long as you don’t put it in context. “We know from history that high inflation rates are totally volatile. That makes forecasts all the more difficult,” says Heinemann. This is why high inflation rates are so dangerous for the economy. “We know even less how much my money will be worth tomorrow. It’s different with low rates, because then they fluctuate less.”

    Nevertheless, many models are also outdated. For years nobody paid any serious attention to inflation – simply because it was not an issue. In these times, this could lead to major forecast errors, says Heinemann.

    Why is the rate in Germany so different from that in the US?

    Inflation is not a German phenomenon, states and central banks are fighting against price increases all over the world. Recently, however, there have been encouraging signals from the USA. The inflation rate there in April was also at a high level of 8.3 percent, but it was still lower than in March (8.5 percent). Core inflation excluding energy and food was just 0.3 percent over the same period.

    Is that already a harbinger for Europe? Not really, says economist Heinemann. “We see a huge gap in energy between Europe and North America. The political issue there is oil, and there are only very moderate increases in electricity and gas. It’s completely different here due to the dependency on Russia.” Ultimately, Europe will be attacked from three fronts, North America from only one.

    Do the data already indicate a wage-price spiral?

    The Federal Statistical Office not only presented inflation data today, but also provided information on real wage developments. According to this, income in Germany fell by 1.8 percent in real terms in the first quarter. Inflation rose 5.8 percent, wages just 4.0 percent.

    Nevertheless, economists see a great danger: that wages will be linked even more closely to price developments and thus exacerbate price developments – the so-called wage-price spiral would be set in motion, which many economists regard as the worst-case scenario. It would probably only be possible to stop it at great expense, with massive losses in prosperity as a result. ZEW economist Friedrich Heinemann now also believes the scenario is possible.

    “I was reluctant for a long time, but now we’re getting closer to the spiral.” That’s not so much an inflation argument as a labor market argument. Because the unemployment rate is now below the pre-pandemic level. In addition, never before have so many companies considered the shortage of skilled workers as an obstacle to production. Such an environment drives up wages even without an inflationary environment. The current situation only provides additional dynamics.

    What can the federal government and the central bank do against the development?

    One thing is clear: the European Central Bank has the most effective (monetary) levers against inflation. However, this has to be a balancing act: stopping price increases without choking off economic growth. The ECB is therefore trying to set the key interest rate “neutral” – i.e. in such a way that the economy and prices grow at about the same pace. However, this neutral interest rate is not so easy to determine, and economists have been debating just the best formula for many years.

    In the short to medium term, however, the aim is to dampen inflation expectations. The ECB could do that by raising interest rates and aggressively declaring war on price increases. The ECB has already announced that it will raise the key interest rate by at least 50 basis points. Politically, the scope is more limited.

    Finance Minister Christian Lindner has already stated that he wants to present a balanced budget in the coming year. In concrete terms, this means that the state is pumping less money into the economy. For economist Heinemann, however, this can only be part of the answer. “Politicians’ honest answer should be: People, you’re all getting poorer. Because that’s going to happen. We’ll get poorer in years of pandemics and wars. Inflation is the mechanism that enforces that.”

    Germany is currently experiencing a supply shock. During the pandemic, politicians created a phantom income for six million short-time workers, although they did not really create value. “So they could continue to consume, but didn’t produce any goods,” explains Heinemann. In this respect, inflation is a kind of equilibrium reaction.