Inflation in 2022: Temporary or a cause for serious concern?

The governing council of the European Central Bank (ECB) in December argued that the rise in prices evident in the EU would continue well into 2022 but thereafter abate. So, steady as you go in essence.

While the ECB has maintained that inflation is temporary and will come back under target on its own, a growing number of policymakers and commentators are voicing concern that a less benign outcome is also possible. Wage growth pressures are the worry.

The ECB, however, argues that there is no evidence that wages are reacting to temporary price pressures. But it accepts that wage growth is expected to be higher in 2022 than in 2021 and that it must stay vigilant with respect to the evolution of wages and the wage-bargaining process.

Just because we have had very low inflation for many years in the recent past should not blind us to the possibility of higher inflation rates becoming embedded again.

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A well-run economy must have regard to the objective of financial stability. Economic and financial stability has three dimensions: macro-stability, which refers to the avoidance of boom-and-bust cycles; financial stability, which is concerned with the viability of the banking and financial system; and price stability.

Note that the three types of stability are interlinked. Maintaining price stability can be one of the most effective ways of avoiding macro fluctuations; and ensuring macroeconomic stability lessens the risk of instability in the financial sector.

A small region in a currency union will experience price stability only if the centre provides it. In Ireland’s case the centre is Frankfurt, the headquarters of the ECB. Each country, including Ireland, then must operate in terms of managing costs within that price framework.

Stability defined

The ECB defines price stability as year-on-year increases in the consumer price index of the euro zone of 2 per cent, maintained over the medium term. The commitment to this target is symmetric. The ECB views inflation that is too low just as negatively as inflation that is too high.

The ECB views inflation that is too low just as negatively as inflation that is too high

Why is consumer price stability important? Although asset prices such as for housing have attracted much attention in recent years, it is useful to also consider consumer prices. Failure to achieve price stability impacts adversely on both economic growth and income distribution. Deviations from price stability can take the form of inflation or deflation. Of the two, inflation has presented the more prevalent and persistent danger historically. What are the dangers though if inflation becomes embedded again?

First, uncertainty about the inflation rate undermines the role played by money in saving on transaction costs. For example, fixed-price orders and other explicit long-term contracts are important ways of assisting forward planning. Uncertainty about the future price level shortens the time horizon of such agreements, thus imposing a loss on businesses and the economy in general.

Second, the haphazard nature of the income distribution effects of inflation can also lead to social unrest and general discontent as people find it increasingly difficult to estimate the growth in their real incomes and to predict what their real earnings will be in the future.

Salary spiral

In a period of 1 per cent inflation, people who receive pay increases of 4 per cent recognise clearly that they have gained in real terms. In the current situation of about 5 per cent inflation – the latest figures show a December rate as high as 5.7 per cent – the danger must be that, if not brought under control quickly, it will set off a wage demand spiral. Already labour shortages are pushing up wages in some sectors but, for many, earnings will not be keeping pace with rising prices.

Labour shortages are pushing up wages in some sectors but, for many, earnings are not be keeping pace with prices

Finally, maintaining price stability can be one of the most effective ways of avoiding macro fluctuations and hence the risk of instability in the financial sector.

The ultimate danger of high inflation rates is insecurity and a breakdown in the social order, as happened in Germany in the 1930s and several Latin American and African countries since. While this is not a danger of concern in the euro zone, the potential danger of modest inflation of say 5 or 6 per cent becoming imbedded and possibly leading to an upward spiral should never be underestimated.

It is important therefore that, by the end of 2022 or early 2023, the ECB ensures that inflation is close to its target of 2 per cent per annum, without jeopardising the economic recovery. This is a delicate balancing act, but the dangers of rising inflation we ignore at our peril. Once out, it is hard to get back in the bottle.

This article is based on Chapter 2, 'Policy Priorities', by Dermot McAleese and John O'Hagan, in the recently published 14th edition of John O'Hagan, Francis O'Toole and Ciara Whelan (editors), The Economy of Ireland: Policy Making in a Global Context