Last winter there were incipient signs of a return to inflation as the euro-area economy recovered from the Covid downturn. Some of this rise in prices was just reversing the fall that had occurred in 2020 as a result of the pandemic-induced recession.
However, because governments were so successful at sheltering their economies during lockdown, the euro area economy surged rapidly back towards full employment. As economies rebounded strongly, the resulting rise in demand ran up against supply shortages due to dislocated supply chains where Covid had taken a toll. This combination of lower supply and higher demand pushed up prices. After a long period when inflation had remained stubbornly below the European Central Bank’s 2 per cent target level, this resulted in a return of significant inflation. If nothing else had happened, the ECB would likely have responded by slowly raising interest rates this year to slow excess demand and bring inflation back towards its 2 per cent target.
Russia’s war on Ukraine dramatically exacerbated the level of inflation, however. The disruption to energy supplies saw a huge rise in oil and gas prices, not just in Europe, but worldwide. If Russian gas supplies are further curtailed, there is likely to be a further major gas price increase over the next six months. It’s expected that world oil supply will eventually adjust, and prices will then fall to a more reasonable level, helping bring inflation down by 2024. However it will take longer for gas prices to drop.
Why are stock markets so volatile right now?
Last week markets worldwide wobbled as investors fretted about a recession and aggressive monetary tightening by central banks.In addition, cryptocurrencies have slumped this year leaving many people nursing major losses. So, is this just a blip, or is there something more fundamental going on? In this episode of The Irish Times Inside Business podcast, Ciarán Hancock is joined by Cliff Taylor of The Irish Times, Aidan Donnelly, head of equities at Irish stockbroker Davy, and Irish Times Washington Correspondent Martin Wall, to make sense of it all and discuss what it might mean for the Irish economy.
In Ireland, since the start of the year, we have experienced a big increase in import prices, especially for energy, which was not counterbalanced by an equivalent rise in the price of our exports. As a result, by the end of the first quarter, Ireland was almost 2 per cent worse off: we had to sell 2 per cent more of our output to buy the same quantity of imports. Since the end of March the situation has deteriorated further. This higher cost of imports represents a real dent in our standard of living, something the Government cannot permanently hide from us.
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If European Union households and companies did not react to their loss of real income, and took the inflationary hit, then it would be relatively straightforward for the ECB to bring inflation back under control. However, already across the EU, households and companies are rushing to try to insulate themselves from the worst of the inflationary surge by raising wages and prices. While it’s natural to want to protect living standards, a wage/price spiral runs the risk of embedding high inflation in our economies.
Interest rates
To bring this inflationary response under control, the ECB will raise interest rates by at least 0.5 percentage points over the next few months. In 2023, interest rates are likely to continue rising with the aim of hauling inflation back to the target 2 per cent by 2024. We don’t know how high interest rates will have to go to achieve this objective but in the decade before the financial crisis interest rates averaged 3.5 per cent.
Higher interest rates can bring inflation under control. Yesterday, the Economic and Social Research Institute estimated that the initial rise in ECB interest rates would reduce house price inflation by 2 percentage points. The effect of higher interest rates is to directly discourage investment by households and companies, with a knock-on effect on consumption. In turn, this lower demand will ease the labour shortages that are driving up wages and labour costs. Unemployment may rise, weakening wage pressures. Reduced demand will incentivise companies to moderate their prices to maintain sales. Gradually inflation will come back under control.
In the 1970s the German and UK central banks, the Bundesbank and the Bank of England, took very different approaches to the 1970s oil price crisis.
The Bundesbank quickly raised interest rates, to such an extent that the German currency revalued strongly against the dollar and the pound. With oil prices denominated in dollars, this directly cut inflation, but the loss of competitiveness saw the German economy suddenly move into recession in 1974 and 1975. A very painful process.
The Bank of England, which effectively controlled our monetary policy at the time through our link with sterling, let inflation rip in the UK and Ireland. While this was initially less troubling, inflation continued to grow, peaking in Ireland at 22 per cent in 1975. It took a very long period of severe policies to eventually bring inflation under control.
The ECB should pursue a middle path between these two approaches, avoiding the 1970s German approach of inducing a recession, but still effectively corralling, not ignoring, inflation.
