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Inflation is slowing but will it come back to ECB’s 2% target?

Some analysts fear price growth will remain elevated at 4-5 per cent for a prolonged period, necessitating higher interest rates

The spike in inflation is easing. The rate of growth in prices in Ireland fell for the third straight month in January, according to the latest consumer price index (CPI), which put headline inflation rate here at 7.8 per cent, down from a peak of 9.2 per cent in October.

But some analysts say it is not coming down quickly enough and that the decline might stall at quite a high level, significantly above the European Central Bank’s 2 per cent target rate. The “sticky inflation” narrative may be guiding the more cautious soundings from central banks.

Speaking at an event hosted by the London School of Economics (LSE) on Thursday, Central Bank governor Gabriel Makhlouf warned that the ECB had a long way to go before it gets inflation under control. He also noted that the credibility of central banks had taken a knock. That’s an understatement.

When the uptick in prices first manifested in 2021, the ECB was almost cavalier in its analysis, insisting it was a temporary post-Covid phenomenon, lowballing even the most benign forecasts for price growth. ECB chief Christine Lagarde and the bank’s chief economist Philip Lane were using the word “transitory”, predicting the whole thing would blow over in the second half of 2022, right up until Russia’s invasion of Ukraine effectively ended the argument.


Now the tables have turned. Central banks are playing bad cop, warning the crisis is far from over while signalling interest rates may need to go higher than markets are forecasting.

ECB interest rates are not likely to reach their peak until the summer and a rate cut this year is out of the question, French ECB policymaker Francois Villeroy de Galhau said on Friday.

The recently buoyant mood on global markets was also punctured by two sets of economic data from the US – one showing higher-than-expected export prices, the other showing accelerating producer prices. That prompted speculation that the Federal Reserve would raise rates more than expected and keep them higher for longer. Goldman Sachs and Bank of America are now forecasting three more Fed rate hikes this year.

In his speech at the LSE, Makhlouf also alluded to the need to keep inflation expectations anchored.

“If households, firms and financial markets no longer trust in the ability of the central bank to deliver its inflation target, we will see medium-term inflation expectations begin to drift above it,” the governor said.

Economists have been warning for some time that if inflation expectations become “de-anchored” and workers start demanding higher and higher wages, a wage-price spiral could develop. Getting people to believe inflation is coming down is a significant part of the equation.

The ECB forecasts inflation across the euro zone will dip to 6.3 per cent this year, to 3.4 per cent in 2024 and down to 2.3 per cent in 2025.

However, there is a growing body of economists who think we might get stuck somewhere along that path. The logic here is that price growth has passed from commodities such as oil and gas into services such as rented accommodation, childcare and insurance, which translate more readily into wage demands, reverberating back into higher prices.

The high priest of this analysis is Egyptian-American economist Mohamed El-Erian. He believes inflation, even with the impact of higher interest rates, might stall at around the 4 per cent range. “Increasing wage pressure” is driving this change, he said in a recent article.

“This transition is particularly noteworthy because inflationary pressures are now less sensitive to central bank policy action. The result could well be more sticky inflation at around double the level of central banks’ current inflation target,” he said.

The price of services such as insurance, telecommunications or residential rents tend to be set only infrequently, sometimes once a year. Inflation therefore comes through more slowly but persists for longer. Inflation in these areas is also less sensitive to monetary tightening.

The latest CPI from the Central Statistics Office here paints a mixed picture. Private rents rose by 10.4 per cent year on year in January and were up on a monthly basis while the cost of “miscellaneous good and services” fell year on year, primarily due to a reduction in prices for childcare services, motor insurance premiums and health insurance premiums.

The strength of the jobs market is another factor. ECB policymakers fear tight labour markets across Europe will lead to wage rises, potentially feeding inflationary pressures. Wages in the private sector here are rising at a rate of 4-5 per cent but there are big disparities between sectors and compositional factors that make tracking wage trends in Ireland difficult.

Until recently the big concern of central banks was deflation. Any sudden moves in markets prompted regulators to step in and buy assets, fearing another 2008-style collapse. Fear of financial instability has, however, been replaced by fear of persistent inflation. The old regime of ultra-easy monetary policy has come crashing down and the old bogeyman, inflation, is back.

If El-Erian and others are proved right and inflation doesn’t track back down, central banks will likely have to keep interest rates higher for longer, and that will have consequences for wages (nominal versus real), for house prices and for a myriad other variables in the economy.

Higher interest rates will also drive many so-called “zombie” firms with high debt loads and weak cash flows out of business.

Next month’s ECB rate rise marks the end of the beginning of this inflation crisis. There are still a number of phases to play out.