Where has inflation gone? And should we worry about it coming back?

Many people living in the Republic today have never experienced significant inflation in consumer prices, though house prices are a different story. The rate of consumer price inflation averaged 2.5 per cent per year in the 1990s and again in the 2000s. The last decade has seen inflation average 0.6 per cent per year. Concern about the rate of inflation has faded from popular memory in Ireland. To some extent Germany remains an exception, due to its experience of hyper-inflation in the 1920s. The fact that an earlier generation of Germans saw all of their wages wiped out in a single day by rising prices still colours popular attitudes.

In the past, when economies approached full employment, employees would seek higher wages, fuelling inflation

The experience of many countries in the 1970s helped develop our understanding of what drives inflation, particularly the role of excess money supply chasing a fixed level of output. Around the world, central banks failed to follow through on the insights of economic theory and lost credibility. With a better understanding today, central banks’ policies in most developed economies have established their reputation in managing consumer price inflation.

Faith in the central bank’s commitment to control inflation matters. It means that, even if there is a temporary increase in inflation, for example due to disruption in energy supplies, people expect it to be just a blip. Thus, wages don’t show a big increase, and companies don’t raise their margins, which could give inflation a further boost.

In the past, when economies approached full employment, employees would seek higher wages, fuelling inflation. However, over the last 20 years wages have shown only a moderate increase, even as full employment was reached.

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Globalisation

Changes in the structure of economies, especially globalisation, have played an important role in defusing inflation. If labour is short in one economy, companies shift production to other locations where labour is more abundant – they don’t have to bid up wages to attract employees locally. Similarly, firms have been able to shift parts of their production process to cheaper locations where there is excess capacity.

Technical progress has also raised the quality of the goods that we buy, and cut the cost of related services. For example, what a cheap tablet computer can do today is dramatically better than what a personal computer could provide 20 years ago, and what a large mainframe computer could deliver 40 years ago. This has meant that buying computer services, such as video calls at work or to friends and family, comes at no additional cost to owners of suitable equipment, and the equipment itself costs a fraction of what it did in 2000.

The credibility of central banks in fighting inflation is well established, so nobody will expect a permanent rise in inflation

The past fear of inflation in Germany was reflected in the remit given to the European Central Bank (ECB) on its establishment of keeping inflation below, but close to 2 per cent. The ECB has failed to achieve this remit over the last decade as euro area inflation has averaged only 1.2 per cent a year. It has excuses for its failure: it was very difficult to raise inflation because the ECB's key instrument, interest rates, cannot be cut much below zero without major problems. Under these circumstances an inflationary fiscal policy is needed to assist the ECB, but it was not forthcoming until now.

Stimulus

Over the last year, governments across Europe and North America have provided a huge stimulus to their economies. However, because people could not spend their incomes, there has been a very big rise in savings. This has substantially neutralised the effect of the stimulatory fiscal policy on national output. However, as discussed in a Central Bank paper published on Wednesday, when we are freed from our confinement at home, there is likely to be a temporary surge in consumption.

However, exceptional savings are not just an Irish phenomenon – they have built up across the developed world. While a surge in consumers’ expenditure in one country almost certainly would not affect inflation, if it happens in a semi-synchronised way in Europe and North America, there could be some temporary upward pressure on prices.

If there was a temporary rise in inflation, this should not be a problem; it may be welcomed. Because a savings-generated consumer boom will run out when savings are used up, any upward pressure on prices will only be temporary. Also, the credibility of central banks in fighting inflation is well established, so nobody will expect a permanent rise in inflation. Thus, while in the past central banks might have risen to the bait and raised interest rates, the ECB has already made clear that such a policy change is some distance away.