THE DEVELOPMENT OF PRICES AND COSTS DURING THE 2008-09 RECESSION ARTICLES In order to assess the infl ation outlook and the risks to it, it is important to understand the The development relationship between infl ation and the business cycle. This article looks specifi cally at developments of prices and costs during the 2008-09 recession and examines whether the responsiveness of infl ation at that time during the 2008-09 was in line with historical experience. It shows that the decline in headline HICP infl ation was recession very strong, largely as a result of the particularly pronounced collapse in commodity prices. By contrast, the reaction of HICP infl ation excluding food and energy was much more limited, despite the extreme depth of the recession. The implied weak relationship with economic slack appears to be related to the presence of downward nominal rigidities in the euro area, which prevented a greater adjustment of wages in response to the recession. In addition, well-anchored infl ation expectations, refl ecting a credible monetary policy, helped to avert the onset of a defl ationary cycle. 1 INTRODUCTION The article is structured as follows. Section 2 assesses whether the developments in euro area The recession that hit the euro area economy infl ation (both overall HICP infl ation and HICP in 2008-09 was of unprecedented depth. infl ation excluding food and energy) at the time Real GDP declined by 5.5% from peak to of the 2008-09 recession are to be viewed as trough, giving rise to a substantial widening exceptional in the light of previous recessions. of the output gap. In this respect, at fi rst Section 3 looks at how commodity prices shaped sight, it is not surprising that the recession developments in HICP infl ation during the latest coincided with a relatively sharp reduction recession and asks why they may have had a in consumer price infl ation, with the annual stronger impact than in previous recessions. rate of change in the HICP declining from Section 4 then focuses on the relationship around 4% prior to the recession, to almost between the infl ation components that are more -1% at its trough. Upon closer inspection, affected by domestic factors (covered by the however, it appears that much of this decline HICP excluding food and energy) and economic was due to the food and energy components of slack, and examines the role of labour costs and the HICP, which tend to be heavily infl uenced profi ts in the adjustment of infl ation. Section 5 by external developments. The adjustment in concludes and offers some implications for the HICP infl ation excluding these components, current outlook. which is more directly related to domestic demand and cost factors, was much more limited. 2 DEVELOPMENT OF INFLATION DURING THE LATEST RECESSION COMPARED Against this background, this article reviews WITH PREVIOUS RECESSIONS the adjustment of prices and costs during the latest recession and compares it with historical Comparing the adjustment of infl ation during experience. Any regularities or idiosyncrasies the 2008-09 recession with that during previous observed in this adjustment could also recessions is diffi cult for many reasons. provide valuable input to forward-looking For example, the adjustment depends on the assessments of infl ation developments. depth and length of a recession. It may also For instance, they could help to shape the depend on whether a recession is driven more assessment of how infl ation is likely to develop by external or domestic factors and on in response to the slowdown in real GDP the macroeconomic policies in place or growth observed in 2011. adopted at the time. Chart 1 shows that infl ation ECB Monthly Bulletin April 2012 71 Chart 1 Overall HICP inflation and HICP inflation excluding food and energy (annual percentage changes) period of recession overall HICP period of slow growth HICP excluding food and energy 16 16 14 14 12 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 -2 19701972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Sources: Eurostat and ECB calculations. Notes: Data prior to 1996 are ECB estimates based on non-harmonised national CPI data. The dates of the periods of recession/slow growth correspond to those identifi ed by the Centre for Economic Policy Research (see footnote 1). developments around the time of the recessions In order to account for the very different levels differed somewhat.1 For instance, the declines of infl ation at the time of recessions over the in infl ation during the mid-1970s and early past four decades, Charts 2 and 3 show infl ation 1980s did not occur until some time after the developments that have been normalised by onset of the recession. During the 1980s dividing them by the mean of infl ation at the time recession the decline also coincided with a (three years preceding and following the trough policy-induced secular disinfl ation process, of the recession). It is evident that the normalised which makes it diffi cult to separate the cyclical movements in overall HICP infl ation during from the structural adjustment. Furthermore, the the latest recession were clearly out of line with 2008-09 recession was unlike the others in that historical experience, while those in HICP infl ation it witnessed very different patterns in overall excluding food and energy followed a more similar HICP infl ation and HICP infl ation excluding pattern to those in previous recessions. food and energy. While overall HICP infl ation fell by 4.7 percentage points from peak to This difference in infl ation developments trough, HICP infl ation excluding food and raises a number of issues. On the one hand, energy declined by only 1.2 percentage points. 1 The dates of the recession periods referred to in this article are Similarly, during the post-recession period those identifi ed by the Centre for Economic Policy Research. The (2010-11) overall HICP infl ation rebounded latest recession thus started in the fi rst quarter of 2008 and ended in the second quarter of 2009. The period from the fi rst quarter of much more strongly than HICP infl ation 2003 to the second quarter of 2003 was described as a prolonged excluding food and energy. pause in economic growth, rather than a fully fl edged recession. ECB Monthly Bulletin 72 April 2012 ARTICLES Chart 2 Overall normalised euro area HICP that the sharp movements in commodity prices The development inflation before and after recessions coincided with particularly strong movements of prices and costs in the global economic cycle (see Section 3). during the 2008-09 recession (normalised annual percentage changes) On the other hand, it appears that the reaction of range during recessions HICP infl ation excluding food and energy, albeit 2008-09 recession average during recessions in normalised terms slightly stronger than in 2.5 2.5 previous recessions, was relatively muted given that the recession itself was much more severe 2.0 2.0 than any of the others over the last four decades. On balance, it would therefore appear that the 1.5 1.5 adjustment in the euro area economy was, to a 1.0 1.0 relatively large extent, attributable to adjustments in quantities, e.g. reductions in the number of 0.5 0.5 hours worked or persons employed, rather than adjustments in prices, for example via lower 0.0 0.0 wage costs (see Section 4). -0.5 -0.5 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 Sources: Eurostat, national data and ECB calculations. 3 THE IMPACT OF COMMODITY PRICES Notes: The chart shows the average and ranges of normalised annual infl ation rates for 12 quarters before and after the last DURING THE 2008-09 RECESSION quarter of each recession (0 = Q1 1975, Q3 1982, Q3 1993 and Q2 2003). For the 2008-09 recession, 0 = Q2 2009. The values have been normalised by dividing by the mean of infl ation over Changes in commodity prices have a direct the chart range, namely three years preceding and following the trough of output during the recessions. The average and ranges impact on the food and energy components of do not include the 2008-09 recession. Data prior to 1996 are ECB estimates based on non-harmonised national CPI data. the HICP, as commodities are either consumed directly or constitute signifi cant input into the it appears that the impact of commodity prices fi nal product. In the case of the energy on food and energy prices was stronger than in component, crude oil is the basis for refi ned previous recessions, possibly refl ecting the fact energy products, such as transport fuels and heating oil. Crude oil prices also have a strong impact on gas prices and, to a lesser extent, on Chart 3 Normalised euro area HICP inflation 2 excluding food and energy before and after electricity prices. In the case of the food recessions component, food commodities, such as wheat, (normalised annual percentage changes) oilseeds, sugar, etc., are an important cost factor range during recessions in the production of processed consumer food 2008-09 recession products, and commodities such as meat, have a average during recessions direct bearing on the unprocessed food 2.5 2.5 component.3 2.0 2.0 Over time, such direct impacts can vary in 1.5 1.5 strength, for two reasons: i) differences in the strength of the commodity price movements 1.0 1.0 themselves; and ii) differences in the strength 0.5 0.5 of the pass-through of changes in commodity 0.0 0.0 2 Oil prices have an impact on gas prices, as gas can be a substitute for oil in some cases, in particular in the generation of electricity, -0.5 -0.5 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 and as many long-term gas contracts are linked to oil prices.