Last autumn, before the war in the Ukraine, it was clear that European Union inflation was picking up. One factor was a bounce back in energy prices, following on their pandemic-induced fall in 2020. Consumers had benefited from cheaper energy in 2020 and the initial increase last year had restored prices to their 2019 levels. If that had been the only factor driving inflation, the European Central Bank (ECB), which is charged with maintaining the rate of inflation at 2 per cent, would have had no reason to worry.
However, there were other factors that suggested that the rise in prices was more than a readjustment to a post-pandemic world.
Disruption to supply chains, which was expected to have a longer-lasting effect, was an important new element. More limited supply weakened competition, enabling manufacturers and retailers to raise prices. For example, a shortage of computer chips hit car production, and scarce supply of new vehicles allowed margins to rise in the car business.
Households had also built up major savings over the lockdown, and some of these savings are now being spent, while supply is slower to respond. More money chasing a fixed supply of goods is the classic recipe to drive up prices. House prices have accelerated, not only here but across the western world, as buyers have savings to spend, but housing supply takes time to expand.
Pent-up savings are also being spent on holidays that had been postponed for two years, as well as other goods and services, putting continuing upward pressure on prices.
War in Ukraine
With these inflationary tendencies, it seemed inevitable that the ECB would have to react by the end of this year, and gradually raise interest rates. However, on top of these “more normal” pressures on prices has come the war in Ukraine.
Initially, the effect of the war was to dramatically raise the price of energy, reflecting a big reduction in world oil and gas supply as Russia was sanctioned. Because demand for energy is unresponsive to prices in the short run, prices have to rise by a lot to clear the market. The result is a big transfer of income from energy consumers, such as Ireland, to energy producers in the Middle East.
Once a market-clearing price is reached – albeit a higher one – energy prices will stabilise. If there was no further knock-on effect on prices, the ECB would not need to react vigorously to prevent an ongoing surge in inflation.
Experience shows that, over time, the supply of oil will respond to the exceptional prices. Higher energy prices will also drive investment in more fuel-efficient buildings, equipment and vehicles. Ultimately, after a number of years, increased supply and reduced demand will lower oil prices from their current peak. The market for gas is more complicated, and the war could see a more permanent effect on prices.
Following the oil price shock of 1973, inflation here rose rapidly and peaked at 21 per cent in 1975
However, this year’s inflation shock is likely to have knock-on effects in Europe as companies and households seek compensation for the real loss of income they have experienced. Companies will seek to recover their margins by raising prices. In turn, workers will seek higher wages in compensation for their loss of buying power. Where firms are able to pass on the rise in costs because of continuing high demand for their products, they will settle for significantly higher wage levels.
Never-ending spiral
The problem is that such a surge in domestic costs could start a never-ending spiral of price increases. That is exactly what happened in the 1970s, following on a series of oil price shocks. In Ireland, where our pound was pegged to sterling at that time, our monetary policy was effectively controlled by the Bank of England. However, the Bank of England failed to react to prevent such a cycle of inflation developing. As a result, things rapidly got out of hand. Following the oil price shock of 1973, inflation here rose rapidly and peaked at 21 per cent in 1975. The then the government’s response to the rising rate of inflation was to plead for wage moderation. Given market circumstances, this was never going to happen.
This time round, it is the ECB that drives our monetary policy. The ECB will not permit inflation to skyrocket. To the extent that domestic costs begin to rise, the ECB will raise interest rates to slow demand. If there is confidence that the ECB will manage inflation effectively, that should help moderate the rise in domestic costs. Hopefully, it will not take a fall in demand, on a scale that causes significant unemployment, to halt an inflationary spiral.
