Inflation surged in 2022 and 2023 with prices rising by an average 7 per cent a year in Ireland and in the euro area. The main causes were the after-effects of the pandemic and the war in Ukraine. However, within the euro area there was considerable diversity of inflation experience, reflecting varying exposure to Russian gas prices and differences in fiscal support for households. Those countries most dependent on Russian gas had the biggest inflation hit, while France, with abundant nuclear energy, saw a relatively small hike in prices.
The mandate of the European Central Bank (ECB) is to target a 2 per cent inflation rate. However, the ECB could hardly have foreseen a global pandemic, let alone the Russian invasion.
To curb inflation, the ECB used its main toolkit by raising interest rates, which was painful. However, it has had the effect of returning inflation to 2 per cent this year. Interest rates are now beginning to ease. Likewise, tough action by the US Federal Reserve and the Bank of England has also brought inflation back to normal in those economies.
[ Irish inflation unchanged in July at 1.5% as food and energy prices remain stableOpens in new window ]
The Covid pandemic that severely disrupted daily life in 2020 and into 2021 had major economic effects. As whole swathes of the economy, such as retail and hospitality, closed during the acute phase, governments protected affected workers and businesses with very substantial payments. This was reflected in very large borrowing by all governments in the Organisation for Economic Co-operation and Development area.
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Much weakened economic growth in the EU has continued, despite the high interest rates. This is a welcome surprise – in the past, such tough central bank action often resulted in recessions
Households, being confined to home, were initially unable to spend their incomes, accumulating very substantial savings. Once the dangers of Covid eased in 2022, people were able to return to normal spending behaviour. Many of them spent some of their excess savings, so consumer demand rose above its longer-term trend, especially in the US where most pandemic-era savings have now been spent. That put pressure on supply chains that were still recovering from the disruptive lockdowns, pushing up prices. A six-day blockage of the Suez Canal did not help matters.
The Ukraine war was the second major inflationary shock, especially to the European economy. In recent decades Europe has relied on cheap Russian gas for heating and to generate much of its electricity. This kept European gas prices low, even in countries such as Ireland that sourced their gas supplies closer to hand.
[ Euro zone inflation falls to 2.2% in AugustOpens in new window ]
After the outbreak of the Ukraine war in February 2022, Russian gas supplies to Europe were suddenly ended, leaving the prospect of a bleak 2022-2023 winter. However, cuts to power and heating were avoided by sourcing supplies elsewhere – although at a high cost. Supplies of liquefied natural gas were diverted from Asia to keep Europeans warm but the cost of energy rose sharply for both consumers and businesses. The US, which is an energy producer, did not experience a similar shock.
Initially there were fears that once the inflation surge began it would pick up its own momentum, as had happened in the oil crises of the 1970s when oil-producing countries restricted supply and hiked prices. As in 2022, energy costs in the 1970s rose sharply in most western economies. At that time, businesses and households sought to compensate themselves fully for the rise in energy prices. This set off second and third rounds of price increases, leading to continuing very high inflation rates.
[ World economy faces pressures similar to 1920s slump, warns Christine LagardeOpens in new window ]
On this occasion, active monetary policies were deployed rapidly to choke off inflation. The ECB raised interest rates sharply, as did the US Fed. This prompt central bank action is why inflation has petered out this time around, unlike in the 1970s.
There was also an expectation from the wider public that the ECB action would work so the credibility of monetary policymaking has enhanced its effectiveness. Patrick Honohan has argued that the ECB started to increase rates before consumer inflation expectations had drifted very far from its 2 per cent target.
Much weakened economic growth in the EU has continued, despite the high interest rates. This is a welcome surprise – in the past, such tough central bank action often resulted in recessions. Nevertheless, because Europe has had to pay a lot more for its energy imports, the EU is worse-off than before the Ukraine war.
Three times in my lifetime, soaring energy prices for fossil fuels have caused major economic disruption: the Suez crisis of 1956, the oil crises of the 1970s and the recent shock. It is another reason why we should decarbonise our economy. Energy-efficient technologies and renewables like wind and solar are good for the planet. But they will also make our economy less vulnerable to shocks from the price of fossil fuels.
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