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Central Banks have one main task: to keep prices stable. What went wrong?

Bankers are beginning to congratulate themselves on having wrestled inflation down reasonably quickly. But the experience should have been a wake-up call

The pattern of price increases has disadvantaged lower income consumers more than the rich, because of what they consume. Photograph: Sasko Lazarov/

It’s a moment to take stock of the surge of inflation that swept through Europe and the United States following the pandemic. For one thing, the main central banks on both sides of the Atlantic expect price rises in 2024 to be close to their target of 2 per cent. Borrowers will have heaved a sigh of relief last week when the European Central Bank at last lowered its policy interest rates slightly after 10 successive increases since mid-2022. Although it is unlikely that the US Federal Reserve or the Bank of England will follow suit when they take their decisions next week, few observers expect further interest rate increases in those countries either. The threat of runaway inflation has receded.

But the 50 months since the onset of the pandemic have seen prices rise by 20 per cent or more on average in the euro area, the US and the UK. In Ireland, the increase has been about 17 per cent – or 19 per cent if one uses the alternative (national) measure that includes housing costs more fully. What went wrong? Why were central banks, whose main task is maintaining price stability, unable to prevent such price increases, and what are the lessons for the future?

Although Russia’s invasion of Ukraine – and the consequential impact on the price of natural gas and other energy products – was a big driver, it is not often recognised how much of Europe’s inflation was imported from the US. Bottlenecks and shortages were the most conspicuous evidence of the world’s manufacturing systems’ inability to meet sudden large shifts in demand as US consumers, stuck at home because of lockdowns, tried to buy goods (for example, home office equipment) instead of unavailable services (restaurants, travel). Recall the pictures of dozens of huge container ships waiting outside congested Californian ports to unload their cargoes from China. Naturally, producers and shippers raised their prices, but the typical US consumer, supported by over-lavish government handouts (going well beyond what was needed to maintain income support) was able to pay.

Not only did higher dollar prices spill over across the Atlantic but, with investors preferring the US dollar with its higher interest rates and as a safe haven, the declining exchange rate of the euro and the pound sterling added to the inflationary impact here. The importance of the exchange rate channel is illustrated by the fact that Switzerland escaped the inflation surge entirely, because its currency too was seen as a safe haven for investors.


The textbooks tell central banks that, when inflation is heading upward, they should increase interest rates to choke off demand and bring the economy back into balance. And that’s what they did, albeit a bit more slowly than the textbook might have indicated. With the euro area inflation surge running several months behind that in the US, the ECB started raising rates about four months after the Fed. Now, notwithstanding the tone of vigilance and caution in their public communication, some central bankers are beginning to congratulate themselves on having wrestled inflation down reasonably quickly and without much of an increase in unemployment. But the experience should have been a wake-up call for those who complacently assumed that inflation could never return as a problem thanks to the credibility of politically independent central banks and their determination to focus on price stability.

Unusually, governments also played a part. Attempts to insulate households from some of the energy price jumps through price subsidies have been more successful than expected. By removing some of the impact of the price spike, governments slowed pressures for wage increases that could have proved counterproductive for workers, without incurring unaffordable, open-ended spending commitments.

Inflation has had widely differing impacts on different groups in society. The pattern of price increases has disadvantaged lower-income consumers more than the rich, because of what they consume. Also, even within the euro area, countries’ experiences have differed sharply. Average prices in Estonia are 40 per cent higher than before the pandemic, whereas just across the gulf, Finland has kept cumulative inflation below 15 per cent.

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Wage rates across Europe are still catching up with the price inflation that has occurred. But not every household has suffered from inflation. Even the effect on borrowers has not been all bad. For example, although borrowers with variable interest rates or trackers have seen a substantial increase in monthly outlays, the real value of each euro of their repayments has been eroded by inflation. The net welfare effect for some categories of indebted households could even prove to be positive.

Producers in many sectors have also gained from the recent bout of inflation – shipping companies, for example, who saw rates soaring in 2021-22 (and are benefiting again from the need to divert container ship traffic from the Suez Canal to avoid terrorist attacks). Banks across Europe have seen profits recover from years of low profitability as they increased their lending rates. The years of monetary easing through the purchase of government bonds by the central banks have left them with substantial cash reserves, so they don’t have much need to bid for deposits to lend out. Irish banks have been able to benefit particularly strongly, partly because competition here is so weak after the withdrawal of so many foreign-owned banks during the financial crisis. It is clear that the Government is itching to do something about this, but an effective and safe policy to control retail interest rates is elusive; governments that have tried to do so have, at best, often seen their efforts resulting in much more acute rationing of credit excluding all but the most creditworthy.

How far further will the ECB’s interest rate reductions go? Observers differ, but few would be surprised if, having jumped from below zero to 4 per cent in the effort to bring inflation down, its key interest rate were to remain above 2 per cent indefinitely. So: some more easing to come, but not very much, and not very soon.

Patrick Honohan was governor of the Central Bank of Ireland between 2009 and 2015