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Inflation is going to fall faster than you think

Cliff Taylor: Household energy bills remain high but once they start to fall, they will fall fast

In a week when motorists were queuing to save a few euro on a fill-up of petrol or diesel, and figures showed grocery prices up by over 16 per cent year-on-year, this is going to sound a bit odd. But the surge in inflation is going to reverse in the months ahead much quicker than had been anticipated.

The signals on energy prices, in particular, are encouraging. We have got tied up, understandably, in wondering when our energy bills are going to fall. But the bigger picture is that, on current trends, once they do start to fall, they will fall fast. Indeed, the drop in wholesale energy prices is already enough to create headlines, as seen over the last week, of inflation across the euro zone falling faster than expected.

There are questions about how much inflation might stick in the system when the big surge is over – and that is hard to tell. This is the big worry of central banks: a permanent uptick in inflation driven by changed expectations of households and businesses and a wage-price spiral. But in key markets such as energy and food – while there may be questions about the structure of the Irish market and profits made here over the years – there is also competition. And as the fall in everything from wholesale energy prices to shipping costs feeds through into reducing the pressure on prices more widely, we should see better deals.

The biggest recent change has been on energy markets, boosted by strong supplies in Europe which has weaned itself surprisingly well off Russian gas. Looking at wholesale gas prices, the price per megawatt hour in Europe– a key factor in inflation trends across the Continent – has fallen from a peak of over €300 last August, and a level of over €150 for around four months last summer and autumn, to €23 on Friday. This is back towards the levels that prevailed before this all started. UK markets, from which Ireland buys directly, show similar trends, with prices there now around 50p per therm.

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The price of gas per megawatt hour in Europe has fallen from a peak of over €300 last August, and over €150 for around four months last summer and autumn, to €23

There is some market nervousness looking out towards next winter, and buying gas for that period is more expensive. The market has still to settle and we can’t be sure that prices for household gas and electricity will go all the way back to where they were. They quite possibly won’t. But significant falls are in prospect moving into next year. And just as this inflationary surge was kicked off largely by rising energy prices, falling costs in this area will be the harbinger of weakening inflationary pressures across the board.

Meanwhile, there are also signs that the blocking up of supply lines and increased transport costs which followed Covid have also reversed, with key container freight prices collapsing back to pre-Covid levels or close. Add these two together and it is difficult to see how food prices will not soon be on the decline too. So the two big drivers of inflation will reverse, leaving us with one question: what will happen to so-called core inflation – excluding these two volatile factors – still at over 5 per cent in the euro zone and 5.7 per cent in Ireland?

It will fall, for sure, but will it drop enough for the European Central Bank to be happy that inflation overall is at or close to its 2 per cent target? The deflationary impact of falling energy and food prices should bring inflation down across the board, but with Ireland at full employment and the domestic economy growing strongly – as confirmed by the latest figures – there remains a risk of price pressures persisting in some areas.

High-cost economy

Rents are the most obvious, of course, but it remains to be seen how embedded inflation has become in other areas. Ireland is a high-cost economy already and we can’t afford to fall further out of line. Even as inflation eases, higher price levels for many goods and services will persist.

Just as the surge in inflation framed much of the political and economic discussion over the past couple of years, its collapse will do the same. It should mean interest rate rises will soon be over. If the ECB hikes much further on the basis of current figures, it will seriously raise the risk of going too far, particularly as growth in some big eurozone economies slows or reverses.

The Government could remain under pressure to support households again heading into next winter, but that should be the end of temporary supports

In the US, there is talk of “skipping” – of the Federal Reserve Board, the American central bank, increasing for the next meeting and seeing how things pan out. Beyond that, markets are now betting that in a couple of years interest rates will have fallen back a bit. We shall see, but if this happens it would remove some of the pressure on those who bought in recent years and will be coming off fixed-rate agreements into a market where interest rates are higher.

A big question in the short-term is how quickly energy prices fall for households. Energy companies say that buying energy forward on the market protected consumers as prices went up, but means they will be slow to start falling. An issue here is the lack of transparency in the market: we don’t know the prices energy companies bought at, so it is hard to judge when prices might fall. All markets are different, but prices to consumers in the UK and in some EU countries are already starting to ease. Pressure will build here on the energy companies to follow suit.

In the meantime, the Government could remain under pressure to support households again heading into next winter, but that should be the end of temporary supports. By next year household energy prices should be falling sharply. This will be the clearest sign to households that the worst impact of inflation has passed. Patience will be in short supply, but it will happen.