Inflation trends in both the US and the euro area have shown a downward trajectory since mid-2022. This decline is largely attributed to reduced energy costs and the easing of supply chain bottlenecks. However, this downward pressure has been partially offset by increases in core inflation components, notably non-energy industrial goods and services, as illustrated in Figure 1. Despite the fall, inflation’s descent has been more gradual than initially anticipated. Even with a significant drop in energy prices, sharper than previous futures market predictions, major forecasts have consistently revised inflation expectations upwards, particularly for the euro area. These upward revisions are primarily driven by stronger-than-expected core inflation figures (Ilzetzki and Jain 2023).
Figure 1 Headline inflation and contribution from main components (year-on-year percentage changes and percentage points)
Source: Refinitiv, Eurostat, Office for National Statistics, Bureau of Labor Statistics. Alt text: A graph comparing headline inflation and its components in the US and Euro area, showing energy and core inflation trends.
Against this backdrop of decreasing energy prices yet persistent core inflation, a crucial policy question arises: to what extent do current high core inflation rates stem from the lagged effects of past energy price surges? Our analysis indicates that energy prices play a negligible role in explaining elevated US core inflation in 2023, but their influence is considerable within the euro area.
Historical Pass-Through of Energy Prices to Core Inflation: A US vs. Euro Area Comparison
Prior to 2020, the transmission of energy price shocks to core inflation was minimal and comparable across both the US and the euro area. We quantify this pass-through speed and magnitude using impulse response functions (IRFs) from a vector autoregression (VAR) model. Our baseline model incorporates consumer energy inflation, food inflation, core inflation, the unemployment rate, and negotiated wage growth.
Estimations based on data up to 2020—preceding the 2021-22 energy price shock—reveal that a 10% shock in consumer energy prices led to a core inflation increase of 0.1% to 0.2% in both the US and the euro area (Figure 2, grey areas). However, when we extend the analysis to include data up to 2023, encompassing the 2021-2022 energy price shock, the responsiveness of core inflation to energy prices appears significantly heightened, especially in the euro area (Figure 2, purple areas). This suggests a break in the established relationship between core prices and energy input costs due to the energy price surge. Figure 2 illustrates IRFs derived from analyses extending to 2023, thus incorporating the substantial energy price shock of 2021/2022, juxtaposed with those estimated from the sample ending in 2020. Following a 10% energy price shock, the peak response of euro area core inflation in the full sample analysis reaches 0.8%, a fourfold increase compared to pre-shock estimates (Figure 2, right-hand side). This amplified impact coincides with increased inflation rate dispersion across the euro area (Goujard and Beynet 2022). In the US, a notable increase is also observed, but the overall impact remains more moderate at 0.4% (Figure 2, left-hand side).
Figure 2 Impulse response functions following a shock to energy prices
Source: Figure 2 from original article. Alt text: Impulse response functions graph showing the differing impacts of energy price shocks on core inflation in the US and Euro area before and after 2021-2022.
A more detailed examination indicates that the heightened sensitivity of euro area core inflation to energy prices is primarily driven by an increased responsiveness to gas and electricity price shocks. This aligns with findings by Boeck and Zoerner (2023) regarding the effects of gas price shocks on core inflation in both the US and euro area.
We hypothesize that the sheer magnitude of the energy cost shock induced a non-linear adjustment in final prices, particularly within the euro area. De Guindos (2023) similarly posits that “the pass-through from the recent supply shocks to underlying prices has been faster and more widespread than before the pandemic,” likely reflecting the unprecedented scale and duration of these shocks. Indeed, the energy price shock in the euro area was historically significant. For instance, between early January 2021 and its peak in summer 2022, spot gas prices in the euro area surged approximately 17-fold (based on TTF prices), compared to a 3.8-fold increase in the US (based on Henry Hub prices). A shock of this magnitude is likely to have triggered non-linear effects throughout the price transmission mechanisms in the euro area.
This explanation is consistent with pricing models where firms face fixed costs for price adjustments. Cavallo et al. (2023) demonstrate that in models with menu costs, “large shocks travel fast.” When firms face substantial production cost shocks, they must decide whether to optimally reset prices and incur menu costs or maintain current prices, accepting reduced profits. The latter option becomes increasingly unattractive as the shock size increases, widening the gap between the current price and the profit-maximizing price (Nakamura and Steinsson 2008, Vavra 2014).
Implications for Current and Future Core Inflation Dynamics in the US and Euro Area
In line with the preceding analysis, the contribution of past energy shocks to current core inflation is minimal in the US, while it is substantial in the euro area. Figure 3 illustrates the contribution of current and past energy price shocks to core inflation, based on the baseline VAR model using data up to 2023.
Figure 3 Contribution of energy and other price shocks to core inflation
Source: own calculations; Refinitiv, Eurostat, Bureau of Labor Statistics. Note: This figure reports the historical decomposition of core inflation. The coloured bars show the contribution of energy inflation, while the grey bars represent the contribution of the other variables included in the VAR (see Appendix B for further details). Alt text: Graph comparing the historical decomposition of core inflation in the US versus the Euro area, highlighting the role of energy price shocks.
The impact of past energy shocks on US core inflation is negligible, supporting findings by Kilian and Zhou (2023) and the greater influence of demand shocks in driving US inflation (Visco 2023). Conversely, in the euro area, energy shocks account for approximately one-third of core inflation by the end of the sample period. Critically, the impact of past energy prices on euro area core inflation appears to have not yet peaked. Considering that energy prices peaked in mid-2022 and the maximum euro area core inflation response occurs after about 20 months, it is probable that the full effect of the energy price shock is still unfolding in euro area core prices.
Two key conclusions emerge from this comparative analysis of Us In Euro inflation dynamics. First, the US core inflation is unlikely to be significantly alleviated by the normalization of energy prices. US core inflation is currently sustained by persistent growth in shelter prices and prices of goods like garments, furniture, and certain non-shelter services. Reducing these price pressures will require time and potentially some slack in the labor market (see also Leigh et al. 2022). Second, the euro area has greater potential for core price deceleration due to declining energy prices. Both goods and services prices in the euro area are still being influenced by past energy price shocks. As energy prices have decreased, they are expected to contribute substantially to cooling down core inflation in the euro area.
Authors’ note: This column does not necessarily reflect the view of the Bank of Italy or ESCB.
References
Cavallo A, F Lippi and K Miyahara (2023), “Inflation and misallocation in New Keynesian models”, ECB Forum on Central Banking, Sintra, 27 June.
De Guindos L (2023), “The inflation outlook and monetary policy in the euro area”, Keynote speech, King’s College London, 7 July.
Böck M and T Zörner (2023), “Natural gas prices and unnatural propagation effects: The role of inflation expectations in the euro area”, VoxEU.org, 30 Apr.
Goujard A and P Beynet (2022), “The surge in inflation dispersion in the euro area: Key drivers and policy responses”, VoxEU.org, 12 Sep.
Ilzetzki E and S Jain (2023), “Prospects for euro area inflation in 2023”, VoxEU.org, 10 Mar.
Kilian L and X Zhou (2023), “The inflationary impact of energy prices”, VoxEU.org, 10 Feb.
Leigh D, P Mishra and L Ball (2022), “Understanding US inflation in the COVID era”, VoxEU.org, 22 Nov.
Powell, J H (2023), “Inflation and the labour market”, 30 November.
Visco, I (2023), “Monetary policy and the return of inflation: Questions, charts and tentative answers”, CEPR Policy Insight 122.
