Earlier action on interest rates than planned may be warranted

When the European Central Bank (ECB) was established it was given a mandate to maintain euro zone medium-term inflation rates below – but close to – 2 per cent. Since the euro came into being in 1999, Ireland's consumer price index has averaged 1.9 per cent a year, right on target.

That average, however, involved some overshooting of the inflation target in the run-up to the 2008 economic crash; while inflation undershot the target over the 2010s. This last year has seen a rapid turnaround in inflation rates. Annual euro zone inflation has hit 5.1 per cent in January; even higher in Ireland at 5.7 per cent.

This acceleration in the inflation rate has a number of causes, many related to the pandemic and how it was managed in major economies. By putting the euro zone economy into cold storage for over a year, and insulating firms and households from the downturn, governments have enabled a rapid recovery as economies and societies reopen. Fiscal policy has made possible a surprisingly quick return towards full employment.

Over the lockdown, households and companies accumulated exceptional savings, which are now giving a delayed stimulus to demand as they are drawn down. These cash piles have enabled consumption and investment spending rebound rapidly.

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Supply lagging

Although demand has risen fast, supply is lagging behind as a result of the pandemic slump and the resulting dislocation of supply chains. More demand with less supply is inevitably pushing up prices. In Ireland, Brexit has added another layer of disruption, pushing up the cost of many weekly items.

Energy prices are a particular pressure point. The temporary slump in energy prices as economies shut down wiped out some suppliers who had high costs of production. Other suppliers who remained in business have tried to recoup their pandemic losses by jacking up prices.

Gas supplies are a special case. The high price of carbon has greatly increased demand from the electricity sector in Europe, as generators switch from coal to the less polluting fuel. There are limited sources of natural gas, and Russia has seen an opportunity to exploit its position as a swing supplier. So gas prices have soared.

So far, the ECB has taken the position that the shock to prices is temporary. It hasn’t seen the need to quickly raise interest rates to choke off inflationary pressures and prevent inflation becoming endemic.

After the end of the second World War, 1946-47 saw a surge in inflation across economies including the US, the UK and Ireland, driven by a similar combination of a savings-fuelled consumer boom, and of supply that was slow in responding.

As today, consumer spending had rebounded as households offloaded the exceptional level of savings accumulated in wartime. Supply remained constrained, until production and supply chains adjusted to peacetime circumstances. However, the surge in inflation proved temporary, with inflation returning to a low level in 1949. The ECB anticipates a similar outcome this time round.

In contrast, the inflationary effects of the energy price shock in the 1970s proved much more enduring. The rise in oil prices set off a chain reaction which resulted in exceptionally high rates of inflation in Ireland, the UK and other countries over the subsequent decade.

The effect of that energy price hike rendered a lot of inefficient capital equipment effectively obsolete. That had a long-term effect in inhibiting supply. Many central banks saw this as a temporary shock, not one with enduring consequences via restricted supply.

By failing to manage demand by raising interest rates, they enabled what might have been a temporary burst of inflation become more permanent.

Strong reputation

Today, the ECB’s strong reputation means it is expected that it will tackle the inflation problem and raise interest rates, even if that action may be somewhat delayed and higher inflation may last longer than expected. The ECB’s credibility that it will act is one reason we won’t repeat the inflation spree of the 1970s. But because economies have rebounded faster than expected, earlier action to raise interest rates may be warranted.

Isabel Schnabel of the ECB council has also warned, however, that the fight against climate change is expected to have a long-term impact on global supply. So, over the medium term, monetary policy needs to become tighter to counteract the potential impact on price stability.

Thus I would not be surprised to see interest rates beginning to rise over the coming 18 months, and stabilising well above their pre-pandemic level over the coming decade.