On the persistence of services inflation and the price of services relative to goods

Summary

Despite the recent increase euro area headline inflation is substantially lower than at its 2022 peak. Services inflation, however, has remained comparatively elevated. Why has services inflation been so persistent, and what does this imply for monetary policy? This policy brief argues that elevated services inflation largely reflects a relative-price adjustment following the exceptional shocks of recent years. This adjustment is primarily driven by real economic forces such as sectoral productivity growth, demand patterns and the uneven propagation of supply shocks, which are largely outside the control of monetary policy. Instead, the role of monetary policy is to ensure that this adjustment remains consistent with price stability. Therefore, services inflation can remain above 2% for some time while headline inflation is close to the 2% target, provided that elevated services inflation does not develop into a broader, self-sustaining inflation process.

Highlights

Persistent services inflation partly reflects delayed pass-through of price shocks 
Energy and supply chain shocks affected goods prices relatively quickly during 2021 and 2022, whereas their indirect effects propagated more gradually through production costs, wages and service sector prices. Pandemic reopening and the shift in demand back towards contact-intensive services reinforced this delayed response.

Recent shocks interrupted long-run rise in relative price of services 
Services prices in the euro area have historically risen faster than goods prices, reflecting differences in productivity growth, household demand and tradability. While the relative price of services went down in response to the surge in goods prices after the onset of the COVID-19 pandemic, it has not yet fully returned to its pre-pandemic trend.

Services inflation may stay elevated as the relative price of services adjusts towards its long-run trend 
Our empirical estimates suggest that around half of the remaining relative-price gap will close within three and a half years, with most of the adjustment driven by services inflation. An exact return of the relative price of services to its long-run trend is not certain, however, as persistently higher energy costs or AI-driven productivity gains in services could alter the future trend.