Inflation Differentials in the Euro Area at the Time of High Energy Prices

Leonor Coutinho and Mirko Licchett

No 197, European Economy - Discussion Papers from Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Abstract: Inflation differentials in the euro area widened in 2022 to historically high levels in the context of a surge in energy and other commodity prices. On the one hand, some degree of inflation differentials within the euro area may be seen as a natural part of an adjustment process, rather than a problem per se for economic policy. On the other hand, persistent inflation differentials can adversely affect competitiveness in higher inflation countries. This paper uses principal component and panel regression models to investigate the drivers of inflation differentials. Our empirical estimates suggest that the asymmetric impact of a common shock – mostly related to the increase in energy and food prices – can explain around half of the increase in headline inflation in 2022 in the euro area. The estimated responses to the common factor increase with energy intensity, reflecting the important role of energy prices in driving global shocks to inflation, and decline with the share of services in Gross Value Added (GVA), suggesting that countries with a larger manufacturing sector have been more sensitive to common factors. The common factor is also found more prominent in 2020-22 than in previous periods. The remainder of inflation developments can be explained by inflation persistence, along with more local and crisis related factors. This persistence might be associated with a relatively long pass-through for the energy shock, related to the staggered nature of supply contracts and price setting in the euro area. Indeed, when estimated without the lagged dependent variable, controlling for residual autocorrelation, our results suggest that common factors can account for up to two thirds of the increase in inflation in 2022 while the contribution of local drivers remains more limited.

JEL-codes: E31 F45 Q43 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2023-11
New Economics Papers: this item is included in nep-eec, nep-ene and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:euf:dispap:197

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