Since the beginning of 2020, the Consumer Price Index (CPI) in the Eurozone has risen cumulatively by almost 20%. In the beginning, central banks expected inflation to be transitory as a result of pandemic-induced supply chain disruptions that should fade out quickly. By mid-2022, inflation was still increasing monthly and central banks rejected their original hypothesis. Following New-Keynesian disinflation recipes, different monetary tightening measures were taken, mostly increases in interest rates. Nonetheless, inflation turned out to be much more persistent than originally forecasted and rising interest rates alone has proven to be a weak response. Now, it is time to rethink disinflation policies, most importantly to prevent future policy mistakes and to gain insight on needed cushion for those hit hardest by recent inflation.

Atypical Euro area inflation

In New-Keynesian models ultimately based on neoclassical concepts, inflation emerges through demand that exceeds supply. Firms can increase their supply until the maximum output of the economy is reached but then, further demand will increase prices.  This is due to a feedback mechanism of both increasing prices for raw materials as well as increasing costs of labor so inflation should be composed of both profits and wages somewhat equally over the medium term. Over the past three years, the ECB’s inflation report showed that inflation had a different composition from the pre-pandemic one: while wage growth contributed only little until the beginning of 2023, corporate profits and imported inflation, which can mostly be attributed to an increase in commodity import prices for energy and food and thus increased corporate profits abroad, have driven inflation to double digits. Such a composition is unprecedented since the existence of the Euro.

Source: IMF, Eurostat, OECD

Why cookbook disinflation policies did not work well

Business cycle theories typically suggest monetary responses to inflation increases based on the well-known Philips Curve. The underlying idea is that policymakers face a trade-off between inflation and unemployment. Through contractionary monetary measures, such as increasing interest rates, economic growth is slowed down because consumption and investment are less attractive in a high-rate environment and in turn unemployment will rise. Ultimately, negotiating power is taken from workers and thus, inflation will slow down due to wage stagnation and decreased purchasing power of consumers.

One of the underlying assumptions for this relationship to be true is the existence of at least somewhat well-functioning markets with a decent level of competition, which should prevent businesses from earning unnaturally high profits. The Eurozone data, however, shows that much of the inflation results from increases in corporate profits instead of wages, so the standard prescription of simply implementing quantitative tightening might not be the only tool to rely on.

Neoclassical economic theory (and those theories that build upon at least some neoclassical elements) state that abnormally high profit margins are related to unperfect competition where single companies have the power to dictate prices. In this case, theoretically well-working market mechanisms cannot function, and regulators should respond accordingly with alternative instruments that are not suitable for standard cases of high competition.

Both the Covid pandemic as well as the Ukraine war led to sudden changes in market conditions that cut off supply chains and thus increased the market power of some participants, such as energy or food supply companies. They were able to increase their prices and subsequently profit margins at least over the short term as it takes time for competition to enter the market. While assumptions of perfect competition rarely hold completely, they hold up to a certain extent for some economic sectors. This level has been well surpassed in the last years both regarding the number of companies as well as the extent.

Fiscal alternatives

Fiscal policies represent alternatives to fight inflation just through monetary ones. Two examples are selective windfall profit taxes and price controls.

Windfall profit taxes can be applied to sectors whose profit margins see a sudden increase because of the prevailing special situation. They should at least inherit a sizeable top-up on the standard corporate tax rate and tax the profits above a certain threshold, such as the pre-crisis profits in addition to some sensible leeway (e.g. a 10% profit increase that could be achieved over one year by normal measures such as efficiency gains). The related surplus tax income for the state should then be distributed among the consumers that have to pay the increased prices to set off the effect at least partially. Examples for such redistributions can be lump-sum transfers, transfers to compensate certain price increases (e.g. for increased gas bills which affect most citizens) or transfers at firm-level to subsidize measures that help to restore competition. Generally, all those redistributions should only affect the overall income- and wealth-decreasing effect of inflation while the price-effect, which directs consumption to relatively cheaper goods, should be unchanged under this policy to ultimately lower demand in affected areas. Examples of recent windfall taxes include the Energy Profits Levy on oil and gas companies in the UK and the windfall tax on banks in Italy.

Price controls are a far less common measure and more difficult to apply effectively. The idea behind them is to set the price of goods to their marginal production costs in addition to some sensible profit margin. The difficulties mostly lie ­in properly estimating marginal production costs. One practicable approach is to determine the average gross margin of products over a comparatively normal period and then set current period prices in a way that reproduces that margin. In this case, firms are still incentivized to increase supply as the gross profit increases on an absolute level and all costs below the gross profit are fixed independent from supply. This approach is more difficult to apply to firms with high fixed costs and high volatility in the supply as these do not have easily analyzable margins. Additionally, price controls come with other disadvantages that hinder their effectiveness. One such example is hidden inflation: companies might sell products at the set price but decrease the quality or the quantity of the products. Thus, the use of price controls is only effective for goods that are highly commoditized and must be applied on pre-specified quantities (e.g. per barrel for oil).

Consequences go beyond inflation itself

The persistent inflation observed in the Euro area in recent years prompts a reassessment of the efficacy of traditional, mostly monetary disinflationary measures, considering also that profit-driven nature of inflation has led to adverse redistributive consequences. With company ownership becoming increasingly concentrated, current inflation increases the wealth of the owners of those companies driving inflation while the non-owners become relatively poorer due to the increasing cost of living. This in turn further increases inequality and creates a reciprocal feedback mechanism. Moving forward, it is imperative to contemplate alternative interventions that take into account collective welfare in the first place.


Sebastian Dullien, Isabella M. Weber, Mit einem Gaspreisdeckel die Inflation bremsen (2022)

Isabella M. Weber, How China Escaped Shock Therapy: The Market Reform Debate (2021)

“Fiscal Monitor 20223: On the path to Policy Normalization”, IMF (2023)

“Governments are proposing windfall taxes on energy firms”, The Economist (2022)

“The effectiveness and distributional consequences of excess profit taxes or windfall taxes in light of the Commission’s recommendation to Member States”, European Parliament (2023)

“What is the windfall tax on oil and gas companies and how much do they pay?”, BBC (2023)