Largely invisible to the consumer, Europe’s inflation looks very different—but it still has bite

May 18, 2021, 12:53 PM UTC

Earlier this month, Europe’s chief envoy for the construction sector sent a desperate note to a trio of EU commissioners.

Supply chains were malfunctioning, he warned. Furthermore, China was hogging the world’s steel, and bark beetle infestations had decimated forests already weakened from drought. The result was nothing less than double-digit hikes in the cost of key commodities.

“I am writing to express alarm about the significant price increase in construction-related raw materials and products, that is currently adversely affecting construction companies throughout the European Union,” wrote Thomas Bauer, president of industry association FIEC. “This phenomenon is jeopardizing the construction sector’s contribution to economic recovery and is threatening the potential impact of European recovery programmes.”

Accounting for 9% of gross domestic product in the EU and supplying almost 13 million direct jobs, construction companies are now scrambling to source more gravel, sand, and gypsum locally to avoid expensive imports. Some even recommend using lumber from logs felled by storms or scarred by pests so long as it is hidden from sight.

Perversely, this sudden price shock may make economists sleep better at night. The input-price inflation suggests the European Central Bank might finally be able to stamp out the long-held fear the eurozone was going the way of Japan and its deflationary spiral.

Consumers spared…for now

Thus far, consumer prices in the euro area remain in the doldrums, stubbornly coming in below their target of an annual rate of increase close to 2% irrespective of a recent surge in volatile energy prices.

With Brussels set to begin next month the first disbursements to EU member states of its vaunted Recovery and Resilience Facility, currently worth nearly €724 billion ($885 billion), the risk rises that inflationary pressures imported into Europe from abroad will stick.

Higher input costs were the dark cloud lurking over an otherwise strong start to the year for European manufacturers enjoying a rebound in demand from American and Chinese customers exiting lockdown.

Take BMW Group. The two key overseas markets, which together account for half its business, powered a 34% surge in car sales to mark its best-ever first quarter. 

Finance chief Nicolas Peter said now was not the time to follow competitors in hiking the earnings forecast. The reason: punishingly high input costs—particularly, steel and precious metals. 

“Beyond the semiconductor [shortage], it’s important we highlight this issue,” he told reporters during an earnings call last week.

Hedging contracts helped the automaker to substantially dampen headwinds from commodities in the first quarter, but the second half would not be as kind as prices begin to feed through into their bottom line. Their drag on 2021 earnings, Peter warned, will be anywhere from €500 million to €1 billion euros ($610 million to $1.2 billion).

“Whether this is a reflection of an overheating economy, or whether we will later see a correction, can only be speculated,” he added.

“Highest one-day price surge”

ThyssenKrupp, Germany’s largest steelmaker, is just one reason behind BMW’s concerns. Much of its supply contracts to the auto industry feature quarterly price adjustments to account for changes in the cost of goods. Facing an epic boom in commodities prices to fuel its blast ovens, the company will look to pass these price increases on to customers.

“Just yesterday we saw the highest one-day price surge for benchmark iron ore contracts since records began,” ThyssenKrupp finance chief Klaus Keysberg told reporters last Tuesday. 

As recently as November, the sequential monthly rate of increase in euro area industrial producer prices (excluding energy) was stuck at around 0.1%—more or less unchanged from pre-pandemic levels. In other words, if there were any inflationary pressures, they weren’t getting past the factory gate. 

That changed with the announcement of the first vaccines being authorized for use at the end of last year. That latest figure, from the March reading, showed a 30-basis-point surge over the level four weeks prior to reach 0.9%. Factor higher energy costs back in, and compare it to the previous year’s month (rather than February), and suddenly you’re talking a 4.3% jump.

Much like their opposite numbers at the Federal Reserve, the 25 members of the ECB’s Governing Council have concluded price gains are just idiosyncratic and transitory in nature. Staff projections pinpoint inflation at a subdued 1.4% in 2023 as significant slack in the labor market puts a ceiling on collective wage bargaining rounds.

Perhaps considering the deflationary effect from a likely wave of corporate insolvencies once various moratoriums end, central bankers seem to welcome the upward pressure on factory prices spilling over onto households.

“It would be welcome if this translated into higher inflation expectations more broadly,” the ECB said in minutes from its April policy meeting published on Friday.

Swallowing costs

IHS Markit last week argued there was a reason for the central bank’s sanguine view. Even as the euro area’s services sector was registering its fastest rise in operating expenses in 15 months, competitive constraints thwarted most efforts by companies to pass on costs.

“While the revival in the economy is bringing a rise in inflationary pressures, these so far seem largely confined to the manufacturing sector, with service sector costs—which form a major component of the core inflation measures tracked by the ECB—remaining only modest,” said Chris Williamson, chief business economist at IHS Markit, in a statement. 

The closely watched German business climate index published by the Ifo Institute is widely seen as a leading indicator for growth in the world’s fourth-largest economy. It found that nearly half of Germany’s manufacturing sector complained of problems getting the parts they need.

“Of the companies surveyed, 45% reported bottlenecks in the supply of intermediate goods, the highest value since 1991,” it wrote in its April report.

One of these feeling the pinch is Volkswagen’s Traton Group, owner of brands Scania and MAN. The commercial vehicles subsidiary, which is acquiring U.S. partner Navistar as early as July for $3.7 billion, posted record quarterly new orders for heavy trucks earlier this month.

“This really hits the nail on the head. And it’s not just steel, either, it’s rubber and plastic as well,” chief executive Matthias Gründler said during a briefing with reporters last week. “It’s causing both a spike in prices and shortages along the supply chain, so it’s of great concern to us.”

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