The inflation wave that gripped Europe and the United States following the pandemic provides a moment of reflection. The primary central banks across Europe and the US anticipate that by 2024, price increases will approach their 2% target. Borrowers would have breathed a sigh of relief last week as the European Central Bank finally made a minor reduction in their policy interest rates after an uninterrupted chain of ten increases since the middle of 2022. While it appears improbable that either the US Federal Reserve or the Bank of England will replicate this move when they make their decisions next week, a limited number of analysts predicts any further rate hikes in these countries. The imminent danger of uncontrollable inflation seems to have passed.
However, the eurozone, the US, and the UK have seen an average price surge of 20% or more in the 50 months since the pandemic began. In Ireland, the jump was around 17%, or 19% when considering the substitute (national) metric which incorporates housing costs more heedfully. So, what really happened? Why were the central banks, tasked primarily with preserving price equilibrium, incapable of halting these price surges, and what implications does this have for the future?
Although the effect of Russia’s intrusion into Ukraine – particularly on the prices of natural gas and other energy products – was substantial, it’s not widely understood how much inflation in Europe was a repercussion of US conditions. Obvious illustrations were the outages and scarcities resulting from global manufacturing systems’ incapacity to cater for sudden, significant shifts in demand when US buyers, confined to their homes due to lockdowns, opted to purchase goods (like home office utensils), as opposed to inaccessible services (such as restaurants and travel). Images of colossal container ships queued outside overloaded Californian ports, awaiting to unload Chinese deliveries, serve as a reminder. As a logical consequence, manufacturers and freighters increased their prices, yet the typical US buyer, buoyed by excessively generous governmental handouts (well in excess of necessary income maintenance), could accommodate these costs.
The surge in dollar prices not only reverberated across the Atlantic, but the declining euro and pound sterling exchange rates – due to investors favouring the US dollar for its superior interest rates and perceived safety – exacerbated the inflationary effect locally. The role of the exchange rate conduit is underlined by Switzerland’s evasion of the inflation surge, courtesy of its currency also being considered a safe investment harbour.
The narrative of economics textbooks dictates that central banks should ramp up interest rates in response to rising inflation, thereby reducing demand and restoring economic balance. This is a strategy that has been adhered to, albeit at a slower pace than suggested. Despite the Eurozone’s inflation trend trailing behind the US’s by a few months, the European Central Bank (ECB) began increasing rates around four months post the Federal Reserve. Central bankers are now beginning to pat themselves on the back for efficiently subduing inflation with minimal effects on employment rates, despite the vigilant and cautious rhetoric in their public statements. However, this should serve as a wake-up call for those who were on the misguided belief that the return of inflation would not be a threat, thanks to the allegiance of politically autonomous central banks to price stability.
Interestingly, state controls also had a hand in this. Efforts to safeguard households from energy price hikes through price subsidies proved more effective than anticipated. By mitigating the price surge’s effects, state interventions effectively curbed wage increase demands that could’ve been detrimental to labourers, without incurring unsustainable costs.
However, inflation has affected various societal groups in widely disparate ways. The economically disadvantaged have felt the burden more due to their consumption habits. Furthermore, the effect of inflation has been dramatically inconsistent across the Eurozone, with the average prices in Estonia rocketing 40 percent since pre-pandemic times, contrary to Finland where cumulative inflation has been kept under 15 percent.
Although wage rates across Europe are still adjusting to inflation, not every household has faced the brunt. In fact, those in debt have seen some benefits. For instance, despite seeing a substantial uptick in monthly expenditures, borrowers with variable interest rates or trackers have experienced their repayment’s actual value diminish with inflation. This could possibly lead to a beneficial outcome in terms of net welfare for some indebted households.
A rise in inflation rates has brought noticeable benefits to producers across various sectors. Shipping businesses, for instance, enjoyed a surge in rates across 2021-22 whilst also profiting from the redirection of container ship traffic away from the Suez Canal, a change enforced in light of terrorism concerns. Moreover, European banks are witnessing an increase in profits following an extensive period of low profitability, largely due to boosted lending rates. Extended periods of monetary easing through governmental bond purchases carried out by central banks have provided these institutions with significant cash reserves, reducing their requirement to bid for deposits to loan out. Irish banking institutions have particularly reaped the benefits of this situation, mainly as a result of reduced competitiveness following the exit of a large number of foreign banks during the financial meltdown. The government appears to be keen on implementing changes to address this, yet the search for a sound and secure policy to manage retail interest rates remains challenging. Past attempts at such interventions have frequently led to stricter rationing of credit, oftentimes favouring only the most credit-worthy.
As for the European Central Bank’s (ECB) future interest rate reductions, predictions vary. However, many anticipate that following an increase from negative figures to 4% as a measure to control inflation, the key interest rate could continue to stay above 2% for the foreseeable future. Therefore, it’s reasonable to expect further easing, albeit gradual and not in the immediate future.
Patrick Honohan served as the governor of the Central Bank of Ireland from 2009 to 2015.