Inflation differential with euro area calls for structural solutions

This follows from a new Analyse, in which we explore the cause of this inflation differential. And we show that the inflation differential can play a role in reducing economic imbalances between euro area countries. Using an economic model, we examine whether this is the case for the Netherlands.

In principle, inflation differentials can correct imbalance

Countries in the euro area cannot independently adjust their interest rates or exchange rates, making it more difficult to correct economic imbalances, e.g. in the trade balance, within the currency union. However, inflation differentials between countries can have a rebalancing effect. For example, a euro area country that benefits greatly from a temporary increase in world trade may experience a surplus in its trade balance and temporarily higher inflation. The inflation differential relative to other euro area countries may reduce demand for that country’s products. The trade surplus then decreases as a result, and equilibrium is restored in the euro area.

Practice shows that adjustments via inflation differentials are slow

In practice, however, such adjustments via inflation differentials are slow and incomplete, and the Netherlands is a good example of this. A number of imbalances are present in the Dutch economy such as a trade surplus and a tight labour market. At the same time, inflation in the Netherlands is higher than the euro area average. This inflation differential has widened significantly since 2020. Higher inflation here stems from a mix of structural, cyclical and one-off factors. Structural factors include high productivity growth in the manufacturing sector and subsequent wage growth in other sectors. as well as the open nature of the Dutch economy, which is sensitive to external shocks. Cyclical factors that contribute to inflation include wage growth and expansionary fiscal policy. Additionally, one-off factors also play a role. These include excise duty hikes and rent increases, which temporarily boost the inflation rate. 

Although the inflation differential can eventually help reduce domestic and external imbalances, the process is slow, as revealed by our simulations with a general equilibrium model. Using this model, we simulate a positive foreign demand shock, which leads to relatively robust economic growth and higher inflation in the Netherlands. Whereas higher inflation contributes to a loss of competitiveness and a cooling off of the economy, these effects are insufficient to reduce imbalances in the economy. Faster wage adjustments in response to high inflation do not accelerate this process. Wage growth may even result in more pronounced swings in inflation.

Investment needed to address imbalances

It is therefore important that policymakers do not rely solely on the automatic adjustment mechanism of inflation differentials, but that they actively pursue policies to correct economic imbalances. In an EMU country experiencing relatively high inflation and an overheated economy, fiscal measures such as scaling back government spending to temper demand in the economy would seem to be an effective approach.

Within fiscal policy, the composition of expenditures can also be adjusted, for instance by spending less on consumption and investing more in measures to remove bottlenecks that hinder economic growth such as an overloaded power grid or other infrastructure chokepoints. Such investments boost potential growth, reducing the likelihood of economic activity running into capacity limits and continuous high inflation.

The same can be achieved by creating space in areas such as the labour market, for example, through the application of new technologies like artificial intelligence (AI). Measures like these strengthen the supply side of the economy while also easing inflationary pressures.