Central Bank’s Donnery says slowing economy may avert ‘wage-price spiral’

Central Bank deputy governor Sharon Donnery said a weakening European economy amid rising interest rates and geopolitical uncertainty, may help guard against a repeat of a damaging wage-price spiral that developed in the 1970s.

“It is vital that central banks remain vigilant around the risks of high inflation, as people’s personal expectations of inflation can become entrenched, and that in itself influences inflation,” Ms Donnery said, as she gave the annual Neri Donal Nevin Lecture in Dublin.

“If higher inflation is expected to persist, then workers will naturally demand higher wages, and employers may in turn raise their own prices,” she said.

While headline Irish inflation touched 9.6 per cent in October and 10.7 per cent across the wider euro area, Ms Donnery said there is “little evidence” at the moment of self-reinforcing wage-price dynamics, where inflation and wages chase each other higher in a prolonged loop.

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The deputy governor said that the current “tight labour market” – with unemployment rates either at, or close to, historic lows in many euro-zone countries as well as high job vacancy rates – will support strong nominal earnings growth of 5 to 6 per cent in Ireland in both 2023 and 2024, and 4 to 5 per cent in the euro zone.

Ms Donnery noted that one of the reasons why the European Central Bank (ECB) has hiked interest rates in recent months – with its main lending rate rising from zero to 2 per cent since July – has been to prevent medium-term inflation expectations becoming “dis-anchored” from the ECB’s 2 per cent target.

The sharp deterioration of the economic outlook, fuelled by the rate hikes, will likely help stave off a wage-price spiral, she suggested. “With a weaker economic outlook, firms will be more circumspect about raising prices for fear of losing customers,” she said. “Equally, workers’ demands for higher wages will need to be carefully balanced against the risk of rising unemployment.”

Ms Donnery attributed that spike in inflation internationally to the “persistent, overlapping and unprecedent scale of supply shocks” in recent years. Consumer demand shifted to goods from services during the pandemic, with widespread supply bottlenecks as countries reopened from lockdowns. That was followed by Russia’s invasion of Ukraine, which has sent energy and food commodity prices sharply higher.

Ms Donnery said that central banks, including the ECB, have “systematically under-predicted even the near-term path for inflation in recent quarters”.

“With both headline and core inflation at very high levels, Central Bank credibility is on the line,” she said. “It is no surprise therefore – and quite right in my view – that the common theme in monetary policy in most advanced economies is a clear and resolute commitment to bring inflation back in line with targets.”

She noted that financial markets are currently pricing in a series of further ECB rate increases to around 3 per cent this time next year for its deposit rate. That points to a rate of 3.5 per cent for its main lending rate.