Fragmenting global trade could trigger higher levels of inflation, warns Central Bank governor

Central Bank governor Gabriel Makhlouf has warned that fragmenting global trade could lead to higher and more volatile levels of inflation.

He said increasing levels of protectionism globally following supply chain shocks from Covid and the war in Ukraine may also result in greater volatility in interest rates as central banks struggle to manage erratic inflation.

Speaking at a conference in Dublin jointly hosted by the Central Bank and the US-based Global Interdependence Center, Mr Makhlouf noted that a narrative has developed “that countries and regions could be better off by reducing their exposure to foreign shocks” and taking back production that had moved offshore in recent decades, during a sustained period of globalisation.

Governments were considering whether the gains from lower-cost imports adequately compensated “for greater susceptibility to shocks transmitted across borders,” he said.

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Mr Makhlouf noted that the International Monetary Fund (IMF) and other international institutions were warning of the “considerable negative effects” from a fragmentation of global trade along geopolitical lines.

“While the size of the economic costs vary across studies, one message is clear: the deeper the fragmentation, the larger the costs,” he said.

[ Irish economy to keep growing even as European Commission warns of ‘persistent’ inflation ]

Moves by the EU and US to reboot computer semiconductor production within their borders through so-called chip acts, last year’s US Inflation Reduction Act, which offers hundreds of billions of subsidies and tax credits for green investments that favour domestic companies, and various initiatives by the EU to protect its interests, underscore a shift away towards what is being described as global fragmentation.

“While it is difficult to predict the exact impact of geoeconomic fragmentation on inflation, it is clear that changes in global trade patterns and shifts in supply and demand could potentially have significant and unpredictable effects on the price of goods and services,” he said.

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Global fragmentation could lead to “an increase in the volatility of inflation”, Mr Makhlouf said.

“This can make it difficult for central banks to manage inflation and may require them to adjust interest rates more frequently or aggressively than they would otherwise.”

[ Irish workers’ wages lag behind inflation as executive pay booms - Oxfam ]

The European Central Bank (ECB) has hiked its key deposits rate from minus 0.5 per cent to 3.25 per cent last July in an effort to rein in inflation, echoing moves by other big central banks globally in the past year. This has increased borrowing costs for households and businesses.

Mr Makhlouf highlighted that Central Bank research “indicates that the costs of reshoring are larger if it results” in local firms being more able to raise prices due to less competition. It also leads to lower productivity, according to the research.

“Greater economic openness exposes local firms to foreign competition. However, efforts to boost the local production of a good would reduce the exposure to foreign competition of existing domestic producers,” he said.

“By signalling a clear increase in preference for local inputs, localisation policies could – unintentionally – encourage firms in supported sectors to increase their price markups.”

As a small, open economy, Ireland is deeply embedded in global supply chains. “Our research also shows that growth prospects in small countries are more susceptible to negative shocks than larger, more diversified countries,” Mr Makhlouf said.

[ ECB warns it will raise interest rates as long as core inflation remains high ]

Mr Makhlouf concluded by saying that we all needed to “avoid turning the reasonable quest for greater autonomy into an excuse to retreat behind borders”.

“Resilience, of course, matters but, ultimately, interconnectedness has given the world prosperity, opportunity and stability, notwithstanding its challenges,” he said.

“If countries become more self-sufficient and rely less on imports, this could lead to a reduction in global trade flows, which would reduce competition and potentially raise the costs and prices,” he said, noting “this channel could be particularly strong for a country like Ireland that is highly dependent on imports”.