Are the terrible twins of inflation and higher interest rates on the way back?

Cliff Taylor: Leo Varadkar raises issue and bonds edge higher

Is inflation coming back? And with it the prospect, in time, of higher interest rates? Tánaiste Leo Varadkar raised the possibility in an interview with The Irish Times and in doing so has touched on a big debate in economics.

It is about how world economies emerge from the pandemic and the impact of the massive stimulus programmes put in place to fight it. When central banks print money and governments spend it, it can boost inflation in normal circumstances.

Of course, where we are now is far from normal – and the longer-term economic impact of the unprecedented economic hit and the stimulus programmes is uncertain.

Indicators

For now, interest rates remain low and EU underlying inflation indicators remain modest. The ECB is committed to keeping interest rates low and money flowing into next year while euro zone finance ministers say budget policy needs to remain loose to continue to support economies.

The debate on inflation has been sparked in the US, where economists are at loggerheads about the impact of a massive $1.9 trillion(€1.6 billion) stimulus programme being undertaken by the Biden administration.

This is pumping in more cash than the economy needs and risks sending inflation sharpy higher, according to some economists, including former US treasury secretary Larry Summers.

Not so, according to other influential economists, including Paul Krugmam, who argues that the US government is responding to something akin to a war or major natural disaster. Inflation is unlikely to take off, he argues, and if it does tick upward the US central bank, the Federal Reserve, can deal with it.

US long-term interest rates have responded to the debate by moving higher. The US 10-year bond yield is now close to 1.7 per cent, it highest level in a year. The Fed now forecasts that the inflation rate could reach 2.2 per cent this year.

However, the Fed said this week that it will not raise short-term interest rates – the rates that affect most consumer borrowing – until after 2023. The implication is that it believes that growth can be allowed to move strongly in the recovery from the pandemic without worrying too much about inflation.

European long-term interest rates – including Irish ones – have edged slightly higher in response to what is happening in the US, but they are being held down by ongoing massive buying by the ECB.

Rate

Economists do not see inflationary pressure on the immediate horizon in the EU. The headline rate of inflation may rise in the months ahead for technical reasons, but underlying pressures remains low. And spending by EU governments, while significant, is not on the scale of what is happening in the US.

So while there are no immediate dangers in Europe, the key issue for Ireland will be what happens as economies emerge from the pandemic, presumably into next year and beyond. For the State, borrowings taken on during the pandemic are at fixed – very low – rates.

The key issue will be the interest rates at which this money must be refinanced in eight to 10 years time, or what new borrowing in a year or two’s time will cost.

For now, there is just no way to forecast how this will play out as the ECB gradually withdraws support in the years ahead. But it is important to recognise that current borrowing rates are extraordinarily low and relying on them continuing would be unwise.

Costs

Borrowing costs are likely to rise in time from current lows, but by how much is very hard to tell.

For Irish mortgage borrowers, all the signs are that interest rates will remain on the floor for the next couple of years.

Beyond that, predictions are very difficult. It will depend on large part in how Europe’s economies emerge from the pandemic and whether Varadkar’s warnings on inflation come true.