www.barrons.com /articles/europe-us-inflation-prices-dfbb9172

Inflation and French Croissants: Why Europe’s High Prices Are So Sticky

Brian Swint 8-10 minutes

The prices of flour, butter, and eggs are skyrocketing in France's capital. Wages are climbing, too.

A short march from the Gare du Nord station in Paris’s 9th Arrondissement, Charles Ye and Maeva Manchon wake early to follow their passion—baking baguettes, croissants, and cakes at the boulangerie they started three years ago.

Sipping shots of searing-hot espresso, they say the problem is that runaway inflation means they are no longer able to pay themselves with the bakery’s earnings. Since Russia invaded Ukraine last year, the cost of electricity has jumped almost four times. Flour, butter, and eggs are all about 50% more expensive, according to the bakers.

“Prices for everything went up, and they’re still going up,” says Ye from the office of his Union Boulangerie. “When it all started, we thought, OK—it’s temporary, Ukraine, we accept it. But now it’s becoming normal.”

There are plenty of complaints about rising prices in the U.S. But for Parisian baguette bakers, it has become an existential crisis. Input costs are rising much faster than Manchon and Ye can raise prices for their goods. It’s a squeeze that is hitting France’s 33,000 bakeries particularly hard. 

Inflation in the euro zone—the 20 countries in the European Union that share the currency—looks to be harder to tackle than it is in the U.S. The biggest reason: The European Central Bank started raising interest rates later than the Federal Reserve, fueling expectations that inflation will last for longer—which could become a self-fulfilling prophecy.

It’s the expectation that prices will probably keep rising that is most dangerous for central bankers, whose job it is to keep the inflation rate at about 2%. While rates are retreating now, there’s reason to believe it will take ECB President Christine Lagarde longer to win the battle against price rises than it will for Federal Reserve Chairman Jerome Powell.

Both were caught a bit off guard by inflation’s return after more than a decade of weak price gains. The emergence from the Covid-19 pandemic provided the spark, but it was Russia’s invasion of its neighbor in February 2022 that poured fuel on the fire. The euro zone’s inflation rate peaked at 10.6% in October and is now at about 7%, compared with about 5% in the U.S.

Policy Parameters

The problem for central banks is they don’t have direct control over the cost of all the things that go in the basket of goods and services measured to calculate inflation. In the short term, there is absolutely nothing the central bank can do to lower the price of electricity or flour. 

Broadly speaking, when the central bank wants to rein in price increases, it raises interest rates to limit the amount of money in the economy. With less money around to spend, companies can’t charge as much, thus inflation cools.

That’s the theory. In practice, there are multiple channels through which monetary policy works. The key point is that the central bank has influence on inflation only at a very early stage in its pipeline. Academics reckon it takes a year or two for rate hikes to do their job.

The other key thing is that monetary policy really only affects the demand side of the economy—how much people can buy. It’s powerless to change the supply side—how much is available for sale.

These constraints create a challenge for central banks. When the prices of things such as energy go up suddenly (supply-side issues that policy makers can’t control), workers respond by asking for higher pay to maintain their standard of living. Higher pay lifts the demand side of the economy, strengthening inflation for the longer term, ultimately forcing central banks to raise interest rates higher than they would otherwise in an effort to get inflation back under control.

The case of Union Boulangerie makes the point. As well as having higher costs for power and ingredients, Ye and Manchon are raising wages for their employees by about 10% and expect to have to do so again next year and the year after, in no small part because everyone expects inflation to stick around. Before, wages were going up only 4% to 5% a year. 

The same thing has played out on a larger scale. Wage growth has picked up substantially on both sides of the Atlantic, but might be more likely to stay stronger in Europe than in the U.S. That’s down to labor unions, more powerful across the pond, bargaining on workers’ behalf.

The Boulangerie Castellane, an artisan bakery that handmakes pastries, cakes, and tarts using traditional techniques, can be found close to the famous Palais Garnier opera house. 

Wiping away the crumbs of meringue and mille-feuille from the display case, Castellane’s Jonathan Coscas tells Barron’s: “If prices are going up, we have to pay more if I want to keep my employees. But the bigger worry is that I’ll lose my customers.”

Energy Sapping

There are other reasons why inflation may prove stickier in Europe. The war in Ukraine is on its doorstep and is still limiting gas supplies, keeping energy prices higher for longer. Governments in France and elsewhere are supporting companies and consumers with subsidies to get through the price spike, but that can also add to inflation pressures by giving people more money to spend.

Across the Seine from Boulangerie Castellane—in the shadow of the Eiffel Tower—is Boulangerie Patisserie Coudrier Geffroy, run by Freddy Coudrier.

“Energy is the big problem,” he says as he prepares lunchtime wine for guests at the bustling cafe attached to his bakery. “I’ve raised my prices by a few cents on some products, but not yet on the baguette. The competition is tough.”

Erik Norland, senior economist at CME Group in London, points out another factor in Europe—countries there are hugely increasing military spending in a way the U.S. isn’t. Defense spending is particularly inflationary because the goods produced aren’t directly consumed in the economy.

Rate Expectations

What’s more, the ECB started raising rates later than the Fed, waiting until July last year before starting its campaign, compared with last March for the Fed. While both started with rates around zero, the Fed has also moved them up much further. Given the lags between higher rates and the impact on inflation, it’s reasonable to think it will take longer for European hikes to kick in.

Moreover, the ECB may not be able to hike as much as the Fed because of how the euro area is set up. The ECB sets interest rates for 20 nations, all with different economic situations and needs. One reason it started so late might be because the last time it lifted rates, it caused huge problems for some countries that had trouble rolling over their bonds at higher rates. The ECB has introduced new tools to prevent similar issues from happening again, though it is well aware that there is always a risk of surprises.

“Central banks tend to raise interest rates until something goes wrong,” says CME’s Norland. “But it’s very possible that here in Europe, they haven’t yet done anywhere near enough to contain inflation.”

The good news is that, eventually, higher interest rates will conquer inflation. It’s painful and takes time, but the track record from the 1970s and early ’80s is the evidence. It just might take a little longer to get there in Europe than in the U.S.

Didier Boudy, president of Mademoiselle Desserts, which supplies cakes to bakeries in France, the Netherlands, and the United Kingdom, said his company is still raising prices as a matter of survival for the business. But he is hopeful that things will change.

“It has been a tsunami of inflation,” he says. “If we were not passing along price increases, we would have gone bankrupt very quickly. Long term, we hope it will ease off and we can reduce prices for some things. But it’s far too early to do it today.”

Meanwhile, bakers in Paris will feel poorer. Manchon and Ye say they’re still happy they are able to make a living from the work that is akin to a vocation, even though inflation is eating up most of their earnings. 

“We can be like this for one or two years,” Manchon says. “But maybe at some point I won’t like working for almost nothing.”

Write to Brian Swint at brian.swint@barrons.com