An economic world turned upside down: Everything you need to know about the cost-of-living crisis

1. What are the origins of the cost of living crisis?

Inflation in Ireland had been really low for years, or at least what we call consumer price inflation had been. Consumer price inflation relates to the costs of goods and services we consume day to day. It has been another story, of course, in the price of many assets, particularly houses.

Inflation started to pick up in the spring of 2021, as the economy reopened after the long post-Christmas shutdown. There was money around (remember that central banks around the world had ensured interest rates stayed rock bottom through Covid shutdowns, and had helped governments to spend billions to try to avert the damage). Jobs had been protected. And better-off households had saved lots of cash through the pandemic. So a big jump in demand happened as economies, including our own, reopened.

But supply has been a problem. China, the source of a lot of manufactured goods, was opening and closing as Covid waves came and went, and across the world global supply chains experienced bottlenecks. Energy prices started to rise too as supply struggled to restart.

Slowness of supply is still a major problem. “Shipping containers full of products have been stuck at ports, slowing down supply chains, wasting time and making production more expensive,” according to Gerard Brady, chief economist at IBEC, the employers’ group. Shipping times from China to Europe increased from between 50 and 60 days in normal times to upwards of 120 days in April, he points out, and are still at about 90 days, while the cost of shipping from East Asia to Europe has risen fivefold.

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The result was a big jump in the rate of inflation, which went from an annual rate of about zero at the start of 2021 in Ireland to 5.5 per cent by the end of the year. The match had been lit. But at the turn of the year we didn’t see the blaze that lay ahead.

2. Is the surge in inflation this year all Vladimir Putin’s fault or are there other people I can blame?

There is no doubt that the war in Ukraine has been the big factor in turning a cost-of-living problem into a crisis. It has sent energy prices surging higher. And while oil prices have come back down a bit, wholesale gas prices, which indicate what is coming down the line for consumers, are at worryingly high levels. This is because Russia is limiting the flow of gas to Europe; the EU previously relied on it for about 40 per cent of its gas.

Higher gas prices affect consumers directly. They also feed through to electricity prices; about half of our electricity on average comes from gas-fired stations. And as a lot of big industries are powered by gas, this also pushes up production costs for many manufacturers, putting further upward pressure on prices.

Ukraine is also a big grain producer. Loss of supply from the region, and fears about the harvest this year, have pushed up food prices everywhere. A recent deal to allow movements of ships through the Black Sea may ease these pressures, if it sticks. Add this to continued post-Covid still-bunged-up supply chains, and we have something of a perfect storm, with inflationary pressures starting to spread right across the economy.

Another key inflationary pressure in the domestic economy has come from a hangover from Covid: labour shortages. As wages are bid higher, consumer businesses in particular are under pressure to increase prices.

3. Is Ireland less exposed than other countries?

Yes and no. We saw how the economy was more resilient than many others through Covid. And Ireland does not import Russian gas, so supply is not directly hit when the Kremlin turns down supply. But higher gas prices could have a big economic impact.

“When it comes to energy security, it’s useful to distinguish between two types of security: physical security and price security,” according to Dr Muireann Lynch of the Economic and Social Research Institute (ESRI). “Physical security concerns whether we have the actual units of fuel or electricity required. If there is fuel in the pump or if the lights don’t go out, we have physical security. Price security concerns the price we pay for our energy: if energy is physically available, but prohibitively expensive, then that is an energy security concern.”

She warns “the knock-on impact on prices means that we are vulnerable” if gas supplies to the EU fall, even if physical supply to Ireland remains available.

A surge higher in gas prices to consumer and businesses is the biggest obvious economic threat heading into the autumn and winter. This could, for example, lead to some companies have to cut production lines or even face closure as costs soar.

4. What do we really understand about inflation anyway?

Inflation is a rise in the general level of prices, as measured in Ireland by increases in the Consumer Price Index, which measures the cost of a fixed “basket” of goods and services. It is now increasing at an annual rate of 9.1 per cent. In the landmark textbook The Economy of Ireland, Trinity College professors Dermot McAleese and John O’Hagan point to the importance of what economists call price stability, which they define as “the absence of any persistent and pronounced rise or fall in the general level of money prices.” Because deflation, a falling general level of prices, is potentially very damaging, the ECB targets a moderate inflation rate of 2 per cent.

Inflation is damaging because it creates uncertainty: business and consumers do not know where they stand, especially with inflation at high levels. And of course, it also hits people’s living standards as they can buy less with their incomes. Now living standards are falling for the first time since the recovery from the 2008 financial crash, and falling quite significantly for most households.

Because they spend a higher proportion of their income on energy and food, less well-off households are being hit hardest. The Central Statistics Office (CSO) estimates their inflation rate is now more than 10 per cent, and most have little or no leeway in their weekly budgets to cope.

The outlook for inflation remains deeply uncertain. We don’t know whether we are looking at what might be a once-off jump in the price level before the rate of inflation eases back, or a longer-term rise in the inflation rate. The world as we have known it since the 2008 financial crash seems to have been turned on its head.

5. Aren’t central banks meant to be able to control inflation?

They like to think so. But they have their work cut out now. The main tool at their disposal, higher interest rates, is designed to slow demand in the economy, but has no immediate impact on soaring energy and commodity prices or paralysed supply chains. Of course, if demand slows and money is taken out of the economy then inflation will fall eventually, but the worry is that in the meantime higher interest rates will turn a slowdown into a recession

Central bankers say that wringing inflation out of the system may involve some pain, but allowing a high inflation rate to become embedded would be much worse. The nightmare for central banks is what is called “stagflation”: slow growth but persistently high inflation, last seen in the two oil crises during the bellbottom era of the 1970s. They worry that if people’s expectations of inflation change, this can become a self-fulfilling prophecy. (Central bankers turn the jargonometer here up to 10 and refer to this risk as inflationary expectations becoming “deanchored.”)

Central bankers are warning that the era of low inflation and low interest rates may be over. Covid and the war in Ukraine may have changed the way economies work, they warn, by ensuring businesses do not focus solely on cutting costs. But also note the recent comments of the chairman of the US Federal Reserve Board (its Central Bank) who conceded that forecasting is very difficult and that “we understand better now how little we understand about inflation”. Which is honest, if a little worrying.

6. So we may be looking at significantly higher interest rates to control inflation?

Yes. We are likely to see another ECB interest rate hike, probably of half a percentage point in the autumn (they just increased the rate by that same level, driving mortgage costs higher). And the Central Bank will want at least one more rise before the end of the year and more in 2023. The unknown factor remains the energy crisis; if the EU slips into recession, then the argument for higher interest rates to control inflation could be undermined. And as the cost of money rises, a lot will change. The financial markets are very nervous.

7. What does this mean for house prices?

House price growth slowed significantly before Covid but has accelerated since the end of the pandemic, driven by Covid savings, rising employment and the well-discussed supply shortages. Now month-on-month house price growth seems to be slowing, though there was a tick back upwards in the last published figures for May. John McCartney, a housing expert who is now head of research in BNP Paribas in Dublin, expects “a pronounced slowdown in house price inflation” in the coming months. He points out that a slowing in monthly growth would automatically bring down the existing annual house price growth rate sharply. McCartney sees a pickup in housing completions to about 28,000 this year, which he believes will also be a factor.

House prices trends will also depend on general economic sentiment and how fast interest rates rise. If the economy is hit hard in the months ahead, confidence will fall and so will housing demand. If it proves more resilient, then prices may hold up. So far, new mortgage borrowing continues to rise, though there is some easing in the growth of new approvals. Supply also remains below ideal levels. Trends in the market in the vital autumn period bear careful watching.

8. What other indicators should I pay attention to?

The economic situation is unusual. All the so-called forward-looking indicators are very weak. These measure consumer and business sentiment and are meant to indicate what will happen next. But the indicators of the actual level of activity (what is going on now on the ground) remain generally firm. Sooner or later the two have to meet.

Sentiment did fall when Covid hit, but then recovered and the economy proved resilient. This time around the fall in confidence looks more threatening. However, the real data is holding up so far. The unemployment rate fell to 4.7 per cent in May, and inward investment reached record levels in the first half of the year.

For now the jobs market remains strong, according to Trayc Keevans of Morgan McKinley, one of the big recruiters, though growth in some areas of the tech sector has recently been a bit slower. Job postings on jobs website Indeed.com show employment trends are still positive, but the company says that the inflow of new jobs postings has slowed. And we have seen share prices of the tech sector plummet. There are mixed signals internationally and in Ireland on hiring in this area. Tech is vital for Ireland, so we need to watch this carefully.

Also keep an eye on the monthly unemployment figures, the employment data and monthly tax revenues. The latter, and particularly VAT and excise returns, will quickly reflect any downturn in consumer spending.

9. As a country, can we manage our way through this?

Higher prices for energy and other imports mean Ireland is less well-off as a country. Politically, sharing pain is a lot harder than sharing economic gains. The Government’s key job is to help the households worst hit and also to support jobs if the energy situation worsens. The Government is likely to help all households in the budget, but it will not be able to stop living standards falling.

10. On a personal basis, is there a smart way to reduce my exposure?

Review your mortgage. If you are on one of the more expensive variable rates and can fix at a lower rate then seriously consider this. Get professional advice first. Be more active in switching to energy suppliers that offer the best deal. If you do have savings, consider carefully how to deploy them: for example in paying down more expensive debt.

11. Are there are economic upsides to this crisis?

Not many. During Covid, at least we saw a fall off in greenhouse gas emissions but now the world is likely to burn more coal in the short term and use more oil if gas prices go higher. Perhaps the crisis will, in time, accelerate investment in renewable energy.

12. What are the best- and worst-case scenarios?

If you wanted to create a worst-case scenario it would be a complete cut off in Russian gas, soaring gas prices and worries about supply and knock-on upheavals in financial markets and the financial sector as recession takes hold. Nouriel Roubini, the Dr Doom of economics, believes we are heading in this direction: a downturn that will be “ugly, deep and protracted”.

The best-case scenario would see an easing of war tensions, an increase in the supply of Russian gas and a sharp fall-off in energy prices, helping to pull down the rate of inflation quickly. Combined with grain exports resuming from Ukraine, this could do much to stabilise prices, and sentiment. This would remove the worst fears about the economic outlook.