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Prices are on the rise again - how worried should we be?

Inflation is back as economies reopen - is this a blip or the start of a trend?

If you’ve had your hair done, priced a new extension or looked at a second-hand car lately, you might have been surprised by the cost. Yes, there is undoubtedly upward pressure on prices.

And, while soaring property prices may attract most of the attention, consumers are facing price surges in a host of different areas. But is it enough to make savers and investors take action, or is the current inflationary environment just a temporary blip as economies start to emerge from the pandemic?

As consumer price figures from the Central Statistics Office (CSO) show, inflation is on an upward curve once more. Latest figures, for May, show that prices rose 0.1 per cent in the month, compared with a decline of 0.5 per cent in the same month in 2020.

On an annual basis, prices are now 1.7 per cent higher than they were in May 2020.

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The big drivers in this, according to the CSO figures, are energy prices, which rose 5.4 per cent in the year; transport (3.6 per cent); restaurants and hotels (2.9 per cent); and alcohol and tobacco (1.8 per cent).

Countering this are declines in a host of other goods and services, including clothing and footwear (-2.1 per cent) and food (-1 per cent).

Property prices are not included in the consumer price index, but these too are on the rise, with growth accelerating to an annual rate of 4.5 per cent in April, the fastest in 2½ years.

The rise in inflation has come suddenly. In January this year, prices also rose by just 0.1 per cent in the month but were down 0.2 per cent over the previous 12 months. This deepened to an annual decline of 0.4 per cent in February.

But as the economy has reopened, and consumer demand has returned, prices have risen sharply – by 1.1 per cent on an annual basis in April and, as we said, by 1.7 per cent in May.

Construction reopened and everyone was looking for raw materials. It will take a while for supply side to respond to that

Ireland is not alone in experiencing this trend. In the US, inflation rose 0.6 per cent in May, pushing the annual rate of inflation up to 5 per cent – the largest 12-month gain since August 2008.

In the euro zone, inflation is running at 2 per cent with a forecast of 1.9 per cent for 2021 as a whole based on the vaccine rollout and further price pressures, while, in the UK, the CPI hit 2.1 per cent in May, considerably ahead of expectations.

Transient or persistent?

But the real question perhaps, is not whether or not we will see inflation this year, as this has already been answered across the western world, but rather is this a temporary, Covid-19 related phase, or is something more fundamental at play?

The president of the European Central Bank, Christine Lagarde, thinks it is more of the former, and has described latest moves as "blips", pointing to a combination of base effects, transitory factors and rising energy prices. Her view, as the bank decided to keep euro interest rates unchanged in early June, is that inflation will rise further in the second half of the year, "before declining as temporary factors fade out".

But others aren’t so sure.

US investment bank JP Morgan Chase says it has been stockpiling cash in the expectation that higher inflation will force a move on interest rates, which will allow it to buy higher-yielding assets.

Indeed JP Morgan chief Jamie Dimon has said there is a "very good chance inflation will be more than transitory". Similarly, back in March, Tánaiste Leo Varadkar said that inflation has to be "on our risk register".

For Oliver Mangan, chief economist with AIB, the surge is likely to be temporary – but may yet go higher. As he notes, if you strip out energy prices, Irish inflation would be more of the order of 0.8 per cent in the year to May 2021, compared with the reported rate of 1.7 per cent.

Recent inflationary pressures are also a factor of sharp price cuts last year. The price of a barrel of oil, for example, fell from $65 to $30 last year. It has since recovered to more than $70.

“There has been a strong upward pressure on prices because of a scarcity of raw materials,” says Mangan. Brexit is also a factor in an Irish context.

“Construction reopened and everyone was looking for raw materials. It will take a while for supply side to respond to that ... And then on top of that, you have this surge in demand.” Mangan adds that the rising cost of being Covid-compliant is another inflationary pressure.

But as Mangan sees it, by next year, many of these price recoveries, or price increases due to supply issues, will have passed through, meaning a return to a more moderate level of inflation of about 1.5 per cent for 2022.

He cites the example of timber. In the US, lumber prices soared due to pandemic-related shortages. However, they have since fallen 40 per cent from record highs in May.

Typically, inflation spiking to 2 per cent in the euro zone might necessitate some action on the monetary policy side. This time, however, things look different

The ECB is also forecasting price growth of 1.9 per cent for this year, falling back to 1.5 per cent next year.

Whatever the long-term outlook, inflation is likely to continue to rise in the short term at least.

“I could see inflation get to 3 per cent later on in the year before falling back,” says Mangan, but cautions that when the year is looked at as a whole, given the negative rates in the early part of the year, the annual rate will probably be more in the region of 1.6-1.7 per cent.

“I would say to households that the fall in inflation last year to -1.5 per cent wasn’t sustained. But the rise this year won’t be sustained either. It will fall back.”

Monetary policy

Typically, inflation spiking to 2 per cent in the euro zone might necessitate some action on the monetary policy side. This time, however, things look different.

"It looks to us that central banks are prepared to tolerate more inflation than they would have 10 years ago," says Ralph Benson, co-founder and head of financial advice with Moneycube. Mangan doesn't see ECB rates rising until 2026.

Governments also have a somewhat vested interest in keeping inflation at bay. With the costs of Covid adding to debt burdens across the world, governments have been able to finance this cheaply – and over the very long-term – thanks to the current interest rate environment.

As Mangan notes, governments “still have a lot of debt to issue” to cover Covid subsidy programmes and so on, so interest rate rises in the short to medium term would be unhelpful.

Irish savers are also stuck with some of the lowest returns in the euro zone, and inflation doesn't look like changing these returns any time soon

“If they shove up interest rates too quickly, it will unwind all that good work,” says Benson.

But with inflation spiking, and interest rates remaining at zero, the coming year may present challenges for savers. Inflation is often described as the “silent thief” of wealth, and this might concern people with money sitting in the bank earning nothing.

For example, savings of €50,000 will be worth just €45,264.35 in real terms by 2031, based on an inflation rate of 1 per cent, or €41,017.41 if inflation averages 2 per cent a year.

Irish people have plenty of money in cash. Irish deposits rose to record levels over the past year, with some €131 billion currently on deposit. Money has also poured into prize bonds, with sales up by 37 per cent last year, and the value of the overall fund growing to €4.1 billion – its highest-ever level.

“Irish people are overweight in cash and property,” says Benson.

At the same time, Irish savers are also stuck with some of the lowest returns in the euro zone, and inflation doesn’t look like changing these returns any time soon.

Savers’ dilemma

Not only that, but some savers are already paying banks to hold their money; soon, more might. A few weeks ago, Bank of Ireland told its customers that, from August 6th, it is changing the terms and conditions on some current and deposit accounts to reflect that it can apply "negative interest rates as well as positive and zero interest rates to these accounts".

There is a benefit in keeping money in cash, as it is secure (up to €100,000 per institution) and liquid.

“So if I’m getting hit up with inflation, that’s the price I pay for that certainty,” says Benson.

“But it’s very different if that money is there because I haven’t found a better alternative, but really I have a five- to 10-year perspective on it.” In such circumstances, it’s “absolutely time” to start thinking about making your money work better, he advises.

The inflationary/low interest rate environment may be most challenging for those coming close to retirement, who may see their savings transitioned into low-risk cash.

As Benson notes, these impending retirees may feel the pinch if their cost of living rises while their investments return little.

From an equities perspective, what’s driving inflation is important. As Benson notes, inflation at present seems to be driven by increased economic activity. “And if that’s what’s driving inflation, that’s absolutely a good environment for share prices to be growing,” he says.

Having said that, equities are a long way into a bull run, and activity and prices have been more volatile recently, particularly in US stocks.