The great price squeeze: when will it end?

The pandemic has been overtaken by a cost-of-living crisis that shows no sign of abating

Fianna Fáil junior minister Seán Fleming stepped on something of a landmine this week by suggesting people should shop around rather than complaining about inflation and the ensuing cost-of-living squeeze. His comments drew an avalanche of critcism on social media. Sinn Féin president Mary Lou McDonald said he was "out of touch" and "indifferent" while Social Democrats co-leader Catherine Murphy described his comments as a "Marie Antoinette moment".

A Government Minister on a €124,000 a year salary must tread carefully when talking about how households can economise. Fleming later apologised. But his comments, however ill-judged, reflect a central fact about the current inflationry surge: governments are powerless to stop it and can provide little in the way of compensation, particularly in the wake of the outlay during Covid. A planned €504 million Government package, the lion’s share of which will comprise a household energy credit of possibly €200, will do relatively little to ameliorate the expected price hikes.

Price comparison website Bonkers.ie said the price hikes could increase annual household energy bills by as much as €1,300. And that’s before you consider the surge in transport costs with petrol and diesel prices up 32 and 36 per cent respectively in the past 12 months; food price inflation and rising rents. Hence shopping around in relation to energy, health insurance, food and other items isn’t as removed or out of touch as it might seem. It may be the only viable course of action for many households.

Rocketed

At the core of the current price squeeze is energy and at the core of that is natural gas. Wholesale prices for gas have rocketed, rising by 470 per cent last year. The jump in crude oil prices was significant (87 per cent) but not of the same magnitude. And because the energy regulator limits the price hikes operators can impose, the full hit of this jump has yet to be fully passed on to consumers. As a result, energy bills will continue to rise in the short term. "The finger of blame for soaring natural-gas prices has been pointed in multiple directions: the weather, the pandemic, general gas production, a slowdown in shallow drilling, OPEC, geopolitical stresses, and so the list goes on," the head of climate solutions at Legal & General Investment Management (LGIM), Nick Stansbury, writes in a recent blog. "But the true source of this looming crisis is long-term underinvestment in a globally diversified, stable long-cycle supply base."

Stansbury claims this underinvestment is predicated on the shift to green energy. In other words, investing in multiyear gas projects is too risky with the EU’s stated objective of moving to net zero.

"Much of the crisis in Europe is our own fault. The region has underinvested for a long time and demonised domestic gas supply, while doing little to address demand," Stansbury writes. As a result he believes the spike in energy prices isn't going away any time soon. This is probably the single biggest threat to the transitory arguments around inflation. Central banks have been telling us – since early last year – that the current price surge is merely a temporary manifestation of the post-Covid unwind, a mismatch between Covid-hit supply and a quicker-than-expected recovery in consumer demand, aggravated by supply chain blockages. But energy stands outside of the Covid narrative and as a net importer of energy and a big importer of gas, Ireland and Irish consumers have no choice but to take the hit.

Financial supports

The global surge in inflation is partly and ironically predicated on two very positive developments: government supports and vaccines. The rollout of financial supports bailed out workers and households impacted by lockdown but it’s also bolstered demand and facilitated a quicker than expected rebound in consumer spending, which has in turn triggered price hikes. The rapid development and rollout of vaccines (at least in rich countries) has underscored this. So in some ways, inflation is the unintended consequence of our successful management of the economic fallout from the pandemic. Central banks and others tell us that this mismatch between supply and demand will eventually correct, leading to more moderate price growth later this year. However, price dynamics are complex and the fear is that we could have what economists call “second round effects” effectively when companies and workers try to insulate themselves by raising prices or wage demands.

If wages start rising as workers demand better compensation for the current cost-of-living squeeze – there’s already strong evidence of this in the US – that can create a wage-price spiral with firms increasing prices to pay for bigger wage bills, leading to a more prolonged period of price growth.

The Central Bank of Ireland warns about second round effects in its latest quarterly bulletin on the Irish economy. "Price dynamics have started to strengthen in some contact-intensive sectors most heavily affected by the pandemic, while, as the labour market tightens, the potential exists for second-round effects through higher wages and other business costs being passed through to consumer prices in the years ahead," it said. "Therefore, while the rate of inflation is expected to decline, it will remain above prepandemic levels and risks to the inflation forecast are judged to be on the upside," it said.

Large increases in electricity and gas prices in coming months are likely to push inflation above the current rate of 5.5 per cent, and the fear is that with the jobs market much stronger than envisaged, a stronger trend in wage growth could emerge, driving a more persistent step-up in inflation.

Irish inflation is expected to rise by 4.6 per cent this year, according to European Commission forecasts published on Thursday, well above the European Union average.

Interest rates

The traditional tonic for inflation is interest rates. Increasing the cost of borrowing curtails spending and investment, reducing the pressure on resources that can drive up prices. But these rates are no longer within the Government's gift and the European Central Bank (ECB) has so far ruled them out for fear such a move will damage recovery. The mood music is changing. ECB chief Christine Lagarde sought to downplay any suggestion of an imminent rate rise at its most recent meeting but there were clear signals that the process around preparing for a rate rise later this year has begun in Frankfurt.

The Bank of England has already increased rates while the US Federal Reserve is expected to adopt three to four rate increases this year. Rate hikes take 18 months to two years to impact, meaning they would have little effect on the current price environment. So by moving to increase rates, central banks are implicity accepting the notion that inflation is no longer temporary.

Much of our financial system – stock markets, company earnings, government bonds, mortgages – is predicated on low interest rates and a significant shift could have far-reaching consequences in a post-Covid, debt-heavy world.

Despite the large national debt, €237 billion and counting, the Government is relatively insulated from a cycle of rate rises as much of the National Treasury Management Agency’s debt is long-dated. That said, this will have to be refinanced at some future date, most likely at higher costs. The bigger short-term impact of higher rates will fall on households and businesses which already pay over the odds for loans here. domestic banks charge a premium for lending into the Irish market. As a result, Irish mortgage customers pay more than twice the euro-zone average. The differential costs Irish consumers almost €80,000 on a €300,000 mortgage over 30 years. Higher borrowing costs – over and above an already high level – is likely to bite if inflation persists.

Spiralling housing costs

It seems odd to lump house prices and rents into the current inflation narrative when we've been struggling with spiralling housing costs for most of the past 30 years. There were fewer than 1,400 properties to rent nationally on Daft at the beginning of February, according to the site's latest rental price report for the final quarter of 2021. In Dublin, there were just 712 properties available, the lowest level since Daft's records began in 2006. At the same time it said rents are rising by 10 per cent year on year while house price inflation, according to separate data from the Central Statistics Office (CSO), surged to another pandemic high of 14 per cent in November, the strongest level of growth seen in the market in over 6½ years. The cost of construction is also rising at near Celtic Tiger levels. The Society of Chartered Surveyors in Ireland (SCSI) tender price index figures show prices nationally jumped by 7 per cent in first half of 2021.

That is up on the 1.3 per cent recorded in the second half of 2020. Higher construction costs, predicated on a more generalised inflation, will – somewhere along the line – feed through into higher prices. The positive is the noticeable pick-up in supply, albeit from a low base. The Central Bank is forecasting that about 25,000 new housing units will be built in 2022, followed by 30,000 and 35,000 units in 2023 and 2024 respectively. The estimated level of demand in the market is 35,000. Many are banking on the old supply-and-demand laws resolving the affordability issue but there is little evidence it will.

Stagflation

The overall take on inflation is now that it will be higher for longer but we won't see any return to 1970s-style stagflation, a period characterised by high inflation and low growth. Rising oil and natural gas prices are, however, remiscent of the 1970s oil price shocks and they represent the biggest unknown in the equation. European Central Bank chief economist Philip Lane is adamant the current burst of inflation is temporary what he calls a "pandemic cycle of inflation" but he seems less certain on energy prices which he said were a "major economic issue" for the euro zone, particularly the geopolitical issues surrounding gas imports. Where all this leaves Irish households is difficult to say, but the current price squeeze is likely to dominate the economic narrative for the coming year.

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