Inflation in Germany has fluctuated strongly in the past eight years, posing particular challenges to economists. As a case in point, many experts had been predicting higher rates of inflation for 2013 to 2015. According to the current issue of the Bundesbank's Monthly Report, one possible reason why they were wrong could be that commodity price movements over the past few years caught experts by surprise, as the ups and downs of the cost of living are largely driven by price movements in the markets for crude oil and food.

Against this background, the Bundesbank's economists examined the extent to which the Phillips curve model explains inflation developments in Germany over the past few years. The original version of this curve suggests that higher inflation rates mean lower unemployment rates and vice versa. For their analyses, however, the Bundesbank's economists used a modified version of the model, known as the New Keynesian Phillips curve. This curve looks not only at the relationship between real economic variables - such as the labour market situation - and the current inflation rate but also takes into account the impact of inflation expectations and external factors on price increases. External factors also include changes in the price of international goods such as, for instance, crude oil.

Oil prices are decisive

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The results of the analyses show that, since 2009, oil prices have indeed had a defining impact on the inflation rate in Germany. By contrast, the estimations suggest that the impact of the labour market situation and the German economy's capacity utilisation rate on inflation are virtually negligible. "In recent years, this is likely to have been attributable, amongst other things, to the fact that the output gap has virtually been closed since 2012," the economists write in the Monthly Report. This means that the economic resources of labour and capital are being used largely efficiently in Germany. In this case, the real economy should be neither driving nor reducing prices.

If food and energy prices are factored out of the equation, the prices of goods imported by Germany, or import prices, play a decisive role. According to the report, capacity utilisation and the labour market situation have made a positive contribution to this core inflation rate since 2012, but the impact of these two factors is rather small.

No risk of second-round effects

In their report, the economists also went into the risk of what are known as "second-round effects", a term used by experts to mean that changes in the inflation rate affect wage growth. This is based on the following relationship: if, for example, trade unions assume, given a favourable labour market situation, that inflation rates will go up, they could bargain for higher wages for their members in order to offset the inflation-induced loss of purchasing power. If firms pay higher wages, the increase in their costs could be reflected in higher prices for the firms' goods. Given the currently low level of inflation, second-round effects are indeed possible, but would operate in the opposite direction: since lower oil prices would in any case lead to an increase in real purchasing power, the wage bargainers would reach lower pay agreements. From a monetary policy perspective, second-round effects are problematic whenever they amplify swings in the inflation rate and thus make it difficult to achieve the price stability target. The report notes, however, that there are as yet no signs in Germany of a particularly high or increased risk of second-round effects.