In many industrialised countries, the inflation rate has been steadily falling for the past several months, largely in line with expectations. But what comes next?
The outlook remains uncertain – not just for next year, but also in the medium term. As regards 2024, there is much to suggest that the trend of falling consumer price inflation will continue, albeit in a less pronounced form. Nevertheless, in terms of the annual average, inflation rates in the advanced economies are unlikely to drop back down to 2% – the target level set by the central banks. Even if this is achieved in the following years – inflation in the medium term is unlikely to consistently drop significantly below 2% again. A variety of structural factors, such as cost disadvantages due to reduced globalisation, are likely to produce increased inflationary pressure. Given its effects on claims development, this aspect is also very important for insurers and reinsurers.
Munich Re Chief Economist Michael Menhart shares some answers:
Inflation rates have been on the decline again for months now. Is this just as we expected?
For the past year or more, inflationary pressure has been declining substantially. Whereas the inflation rate in the eurozone was still above 10% in autumn 2022, today it’s at just under 2.5%. In particular, the effects of Russia’s attack on Ukraine, namely inordinately high energy prices, have now been reversed, i.e. energy is now more affordable compared with last year. In addition, there is a negative price dynamic for many manufactured goods, with import prices now being lower, for example. All this has substantially reduced the inflation rate. And we’re seeing similar trends in the USA.
However, there is still significant cause for concern. So-called core inflation, i.e. without taking into account volatile energy and food prices, is falling far more slowly. Especially in the services sector, inflation isn’t dropping as quickly – which is largely due to wages. The salary increases are clearly exceeding past averages. First of all, because unions receive at least partial compensation for high inflation in the context of collective bargaining. And secondly, because many sectors are facing labour shortages, which means companies have to offer more competitive salaries. Although this dynamic is now dying down a bit, the outlook for wage growth is one of the most important uncertainty factors in inflation forecasts.
When will inflation reach the central banks’ target figure in the world’s major economies?
Most likely, not until the second half of 2024 – assuming there aren’t any new price shocks. And it’s very likely that, in terms of the annual average for 2024, the 2% target level won’t be reached in either the eurozone or the USA – we’re currently projecting 3% average inflation for both economies. As mentioned, this will especially depend on salary development. Actually, the sluggish economic activity we expect to see in 2024 would indicate an easing in labour markets – and therefore less pronounced wage growth. In addition, in such an environment many companies will have less leeway when it comes to prices. This, too, would limit inflation.
This is precisely what the central banks are watching very closely when setting their monetary policy. At the same time, one thing is clear: there is a considerable risk of inflation persistently remaining well above 2%. Though energy or commodity price shocks could contribute, prolonged bottlenecks on the labour markets and correspondingly high increases in labour costs are even more relevant in my view.
Does that mean the days of inflation rates well under 2% are now gone for good? And if so, why?
Even if inflation rates return to the 2% level in the second half of 2024 as expected, what happens next is anyone’s guess. At the moment, there is little evidence to suggest that in the medium term we will see such low inflation rates as we did in the pre-pandemic years.
In the last 40 years, globalisation, demographic changes, digitalisation and deregulation have helped to limit inflation. Some of these factors will now likely flip. Firstly, since geopolitical conflicts are worsening – particularly between the USA and China – we’re already observing a major slowdown in globalisation. If this trend continues, the cost benefits of the global division of labour will likely diminish, while price pressure will increase for many goods. Secondly, demographic changes, particularly ageing Western societies, will likely produce lasting labour shortages, and therefore higher wage growth. Thirdly, after an era characterised by market deregulation and more competition, particularly in the 1990s and 2000s, we are now witnessing a period of re-regulation. This, too, could be conducive to higher inflation. Only digitalisation and automation continue to have an inflation-limiting effect, for example because artificial intelligence boosts productivity growth.
That being said, there is also a new factor: “decarbonisation” and the transformation to a net-zero economy is also likely to drive inflation higher. These inflationary effects will likely only subside in the longer term when affordable renewable energy sources are available in sufficient quantities.
How important are these factors and what do they mean for the medium-term inflation outlook?
First of all: there are a number of indications that, from an economic perspective, volatility will remain high in the years to come, especially with regard to the geopolitical situation. As such, macroeconomic shocks, like those recently produced by the pandemic or the war in Ukraine, could repeat themselves. This factor alone is a source of considerable uncertainty regarding the inflation outlook.
Moreover, just how much of an impact these structural changes will have on inflation in the years to come can’t be precisely quantified. Accordingly, in my view two potential scenarios are relevant: in the first, these effects aren’t very pronounced, causing inflation to level off at just over 2% on average in the second half of this decade. In addition, in this scenario central banks – partly to avoid a loss of credibility – will continue to place their focus on inflation targets and, in the event that inflation rates flare up from time to time, consistently respond with monetary policy measures. Even so, compared to the previous decade – when average inflation for the G7 countries was just 1.4% – we would find ourselves in a structurally changed inflation environment.
By the way, the vast majority of economic experts continue to expect a medium-term inflation rate in of close to 2%. Consequently, the first scenario is also our current baseline outlook for the years 2025–2030.
But there is also a quite realistic scenario in which these changes produce stronger effects, which means we would see inflation of around 3% per year on average. This would pose a monetary policy challenge, as inflation rates significantly above the 2% mark could threaten the central banks’ credibility – on the financial markets, in households and at companies. The important thing to remember: this is not an extremely unlikely scenario – in my view, the probability is roughly 30%.
What does higher medium-term inflation mean for the insurance industry?
Above all, it means higher inflation has to be reflected in pricing. The challenge mainly consists in the still-high uncertainty. After all, should macroeconomic inflation prove to be higher in the medium term than assumed in the baseline forecasts – and in my view, that’s a realistic risk – it would above all negatively affect “long-tail” lines of business like Casualty. In addition, uncertainty will likely remain high for specific drivers of claims inflation as well: for example, wage developments in the care sector, which is facing labour shortages. Furthermore, the costs of construction materials could also be subject to more pronounced fluctuation in the years to come, which would also mean more uncertainty.