ANNUAL REPORT 2008 - Polymer Bank Notes of the World

significantly in 2008, as commodity prices spiked (see Chart C). However, these rises may alsoreflect other factors in addition to the increases in oil and food prices, such as wage developmentsand the strength of consumer demand, in particular in the first half of the year.Second-round effectsIn addition to direct and indirect effects, usually described as first-round effects, a commodity priceshock also entails the risk of what are known as second-round effects, which may put further upwardpressure on consumer prices. Second-round effects typically refer to the increase in consumer pricesover and above first-round effects owing to the impact of the shock on wage bargaining and pricesettingbehaviour. An increase in inflation owing to the direct and indirect effects of a commodityprice shock may lead to second-round effects if economic agents (in particular price and wage-setters)attempt to compensate for the loss of real income caused by past inflation shocks. This may, in turn,affect inflation expectations and further influence price and wage-setting behaviour. In this way, atransitory inflation shock may become entrenched and thus more costly to eradicate.The likelihood of a commodity price shock leading to second-round effects depends on severalfactors, including the cyclical position of the economy, the flexibility of goods and labour markets(in particular the presence of automatic indexation mechanisms affecting wage bargaining and pricesettingprocesses), the formation mechanism of inflation expectations and, most importantly, thecredibility of the central bank.Inflation expectations and labour cost developments may be used to monitor the risk of secondroundeffects. Inflation expectations derived from surveys of professional forecasters rosesomewhat between mid-2007 and mid-2008. Expectations implied by break-even inflation ratesderived from bond yields followed a clear upward trend over the same period, but, with theintensification of the financial turmoil and the subsequent fall in oil prices, there has been aChart B HICP inflation(annual percentage changes; monthly data)Chart C Selected sub-components of theHICP services component(annual percentage changes; monthly data)HICPHICP excluding food and energytransport services (left-hand scale)package holidays (left-hand scale)restaurants and cafés (right-hand scale)5.05.010.04.54.04.08.04.06.03.03.04.03.52.02.02.03.00.01.01.0-2.02.50.02000 2001 2002 2003 2004 2005 2006 2007 20080.0-4.02003 2004 2005 2006 2007 20082.0Sources: Eurostat and ECB calculations.Source: Eurostat.56 ECBAnnual Report2008