OUT OF THE frying pan and into the fire would be a good way of describing it all.
Like a pantomime villain, inflation has returned to the Irish, European and global stages and just as economies were beginning to kick off the initial effects of the pandemic shock.
Almost everything is more expensive than it was a year ago, from energy to fuel to bathroom fittings and Big Macs.
In response, the Government is mulling a fresh range of measures aimed at easing the burden of the surging cost of living, particularly for the lower-income workers and people on a fixed income like a pension — those most at risk of having their purchasing power diminished by rising prices.
On an even wider scale, central banks are either hiking or, at the very least, beginning to hint at raising rock-bottom interest rates in the near future.
But where in the past interest rate hikes would have been the orthodox approach to red-hot inflation, there is a sense that economists, central bankers and politicians are feeling around in the dark at the moment for solutions.
There isn’t really a playbook for how to deal with what’s happening at the moment in the shadow of the unprecedented global disruption of the pandemic.
So what sort of interventions might we see from the Irish government and the European Central Bank (ECB) if the recent surge in prices doesn’t cool down? Or should they stop intervening altogether?
And crucially, could the cure be worse than the disease?
Smoke signals
It might be hard to believe from our current vantage point, but in the months and weeks leading up to the pandemic, the ECB was still trying — and failing — to boost stubbornly low Eurozone inflation.
In fact, not even three years ago, then-ECB Mario Draghi signalled that Frankfurt was “determined to act” to combat the absence of inflation, a long-lingering symptom of the 2008 financial crisis and ensuing recession.
Flash forward to this week and Draghi’s successor Christine Lagarde found herself sending out smoke signals of a different variety.
Having only months ago said she considered it “very unlikely” that interest rates would go up before 2023, Lagarde on Thursday refused to completely rule it out after annual Eurozone inflation surged to a record-high 5.1% in January, well ahead of the ECB’s 2% target.
Markets are now pricing in two Eurozone rate rises this year.
Europe is about to get into a mess trying to combat a supply side inflation with rate hikes. They will only end up with goverment bonds in their balance sheet, a weaker economy. Why? Because bond markets respond to rates. Energy prices, not so much.
— Saki Bigio (@SakiBigio) February 4, 2022
At the risk of oversimplifying it, that would make borrowing — both for households and governments — more expensive, potentially fuelling job losses, business closures and lower levels of public spending.
Moreover, the logic of raising interest rates in the current context is “debatable”, Professor Kieran McQuinn of the Economic and Social Research Institute (ESRI) tells The Journal.
“You increase policy rates to kind of tighten aggregate demand,” he explains.
Traditionally, if demand is running away or is increasing faster than you’d like, you increase policy rates as a way of restricting credit growth and that ultimately tightens and restricts consumer behaviour and spending and results in lower inflation.
But that’s not really the story of what’s happening in Ireland and across the single currency area, McQuinn says.
Traditional remedies
The main drivers of inflation are, at the moment, very specific and mostly unrelated to consumer demand, even if it has recovered sharply over the past year.
He explains, “The higher inflation rate is being driven by higher costs as far as energy and fuel are concerned.
People don’t have a huge amount of discretion around those. At the end of the day, people will spend higher amounts on fuel and energy if they have to.
Supply chain blockages and snarl-ups are the other major factor driving up headline inflation figures at the moment.
“That’s due to the pandemic,” McQuinn says. “So the traditional remedy — raising policy rates — it’s very questionable whether that would achieve the goal the ECB is seeking to achieve.”
What the ECB really fears, McQuinn says, is “what they call ‘second-round effects’ of inflation”, when higher costs begin to feed into wage demands at the risk of inflation becoming more persistent.
European central bankers’ main objective this week has been to send a message to consumers and firms to avoid higher inflation expectations from becoming “entrenched.” But what ultimately matters is that the European economy is doing worse than the U.S. https://t.co/iVqOSpPfVT
— Jon Sindreu (@jonsindreu) February 4, 2022
But we can’t make any hard and fast judgements about wage growth over the past year in Ireland. The data isn’t complete.
According to the most recently available estimates from the Central Statistics Office (CSO), average weekly earnings grew by 5.1% in the 12 months to the end of September last year.
That’s a sharp increase but it needs to be taken with “a pinch of salt”, McQuinn says.
“You have this highly unusual situation whereby you have a large number of job vacancies in certain sectors, especially as we open up,” he explains.
“It’s natural that employers will pay more to attract workers into those sectors. So it’s very hard to say whether inflation is having a major impact on wages and it does require a degree of caution.”
This kind of distortion effect is happening across the board.
The motion of the economy — a shuddering stop in 2020 followed by lurching restarts and stops — during the pandemic has been “contaminating” a lot of economic data, says McQuinn, making it very difficult to compare the “unusual” situation we’re in at the moment with ‘normal’ periods of economic activity.
It could take another year for those effects to “fully wash out” and for us to get an accurate picture of the inflation rate, he says.
Public spending
Meanwhile, it’s becoming clear that, regardless of what the ECB decides, the Government is going to have to get its hands dirty to tackle the surge in the cost of living in the short term.
Ministers are discussing a package of measures aimed at alleviating the burden on households that could include increases to the fuel allowance and an increase to the €113.50 energy allowance announced before Christmas.
Whatever they decided, McQuinn says the immediate responses need to be extremely “targeted at those who are particularly in need” in order to avoid stoking inflation even further.
But this is no time for the Government to get gun-shy about longer-term spending on areas of need like childcare, transport and housing, says Ciarán Nugent, an economist with the Nevin Economic Research Institute.
In fact, improving and expanding public services and the provision of housing could actually be viewed as a way of reducing wage and price pressures in the future if the Irish economy continues its dramatic growth path.
“Ireland is not really your typical high-income EU country,” Nugent tells The Journal.
“Childcare, housing, public transport — these things are lacking and our welfare state is lacking in-depth and breadth relative to other high-income countries. Wages aren’t as important in these countries because their cost of living is much lower.”
Housing cost inflation is a particular concern in Ireland where both rents and asking have risen parabolically during the pandemic.
Nugent adds, “If you want to curtail massive wage and inflation increases in certain areas, you will have to tackle housing real in a realistic way.”
On this point, McQuinn — whose research revealed last year that the Government could afford to borrow and spend more on social housing — agrees.
“Given the relatively higher cost of housing and the pressures that are there on the supply side, I think it’s clear that the government does need to spend more money in terms of increasing the amount of housing supply that it brings to the markets, particularly in terms of social and affordable housing,” he says.
“And by doing that, it can actually help to alleviate some of the cost pressures that are there in the housing market.”
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