Promising news on inflation but the cost-of-living crisis will rumble on

The warm weather across Europe these past few weeks is bad news for skiers – and also for climate change. But it has had an impact on inflation. By cutting demand for home heating it has helped to hold down wholesale gas prices. Household and business bills have, at least, stopped rising. Add in the impact of government support programmes across Europe and the latest official figures, out on Friday, showed the euro zone inflation rate falling much more quickly than anticipated.

Still, that an inflation rate of “only” 9.2 per cent should be seen as positive is a sign of where we have come from. The Irish rate of 8.2 per cent for December is down from 9 per cent previously.

A sharp drop in the inflation rate is good news. And while monthly ups and downs are hard to call, there is a decent chance that inflation will now fall significantly heading into spring, assuming wholesale energy prices continue to behave. The filling up of European storage facilities gives some hope for the year ahead, though another surge in prices heading into next winter remains a risk.

The fall in inflation will of course be trumpeted by politicians as easing the pressure on the public. But even though the rate of inflation is falling, the cost-of-living crisis lives on. The rate of inflation and the level of prices are two different, if related, things. While prices may not be rising as rapidly, they have reached a level that is inflicting pain on households and businesses and will – for the most part – remain there. It would have been a lot worse if inflation remained in double digits, of course, but there is no going back to the electricity and gas bills of 2019, or the food prices for that matter. The price level has ratcheted upwards.

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This is most clearly illustrated in energy prices, where household have typically seen bills more than double – rising by 130-140 per cent in typical cases. Wholesale energy prices have dropped sharply, but remain more than three times higher than their pre-crisis level. Demands for household and business supports will thus continue and, while some of these will be temporary, there may be a need for longer-term measures for worse-off households. The rate at which their bills are rising may slow, or even reverse a bit in time, but the level of prices will remain problematic.

[ Inflation slows, raising hopes that peak has passed ]

Supporting people through the cost-of-living crisis has been compared to what happened during Covid-19, when temporary supports were extended for as long as necessary. But it is different this time. The Covid lockdowns ended and so the need for supports fell away. Now, even when inflation falls, the cost of living crisis lives on, unless we get really lucky and political events allow energy prices to drop back closer to where they had traded for many years. This looks very unlikely, and huge uncertainty remains over the course of the war and its aftermath.

And across the wider economy, the level of disinflation we are seeing in wholesale energy costs will not be repeated. Prices will remain high. It will take time for wages to rise and for households more generally to adjust. The energy shock is a hit to our national living standards – the policy question is how the pain is divided. And how we safeguard energy security in the years ahead and transition to a lower carbon economy powered by low-cost electricity produced from renewables is absolutely central.

Europe is getting through the winter in much better shape than would have been expected. And Ireland, with its exchequer coffers rammed with cash, has some room for manoeuvre

Intensifying pressure on many households, higher interest rates will continue to squeeze the disposable incomes of mortgage holders and other borrowers. The role of the European Central Bank will become ever more controversial. Having called it wrong last year, the ECB has floundered around, saying it will be guided by data in what it does next and can’t give forward guidance about where interest rates will go, while at the same time hinting very clearly that further interest rate rises are on the way.

Now it is tut-tutting and warning that inflation is still a serious problem requiring much higher interest rates – and two further half-point increases are expected in early February and late March. But if inflation falls sharply and economic growth remains under pressure, the ECB is going to come under heavy fire from politicians and the public. Having been too slow to react initially, it now risks going too far.

It will argue that it has to ensure that the sharp rise in energy costs does not turn into a wider inflationary problem. For now core inflation – excluding volatile energy and food costs – remains stuck about 5 per cent. But there are signs that freeing global supply chains and lower energy costs may see it decline, too. And lower economic growth, by cutting demand, will also help. ECB action is already having a big impact on bond markets and there is nervousness, in particular, that high-debt Italy could face pressures in the months ahead. If this happens, the behind-the-scenes pressure on ECB president Christine Lagarde will grow – politicians are only in favour of central bank independence for as long as it suits them.

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So the exit from the period of double-digit inflation looks likely to be prolonged and messy. But let’s look on the bright side. It is a lot better than having to deal with a continuation of rapid inflation. The outlook remains uncertain – markets still believe energy costs over the next year will be three or four times what they were before this all started through last year.

But Europe is getting through the winter in much better shape than would have been expected. And Ireland, with its exchequer coffers rammed with cash, has some room for manoeuvre. The Government will extend the temporary supports – the only question is how – and hope that the first indication of an easing in inflationary pressures is a sign of things to come.