Dr. Ella Kavanagh:

I thank the Chairman for the invitation to this meeting. I will extract some key points from the brief that I submitted to the committee and will begin by giving some background to the current situation.

The current global inflation issue is the outcome of a perfect storm. On the demand side, the pandemic resulted in a change in consumer expenditure patterns from services to goods. The current easing of Covid restrictions and accumulated savings have unleashed pent-up demand. At a macro level, unlike in previous recessions there has been a co-ordinated monetary and fiscal policy response to the pandemic. On the supply side, disruptions to supply chains, difficulties in the labour market due to Covid, geopolitical factors and importantly, climate change consequences and responses, have affected the global commodities market, including the energy market and the supply and availability of raw materials, inputs and products. We are seeing the effect of this and during this year we have entered into a period of rising prices and higher inflation rates.

In July 2021, average prices of goods and services in Ireland measured by the consumer price index, CPI, were 2.2% higher than the average a year ago. This rose to 2.8% in August and, more recently, 3.7% in September. This followed a period of deflation during the height of the restrictions. It is also important to note that over the last decade low inflation of less than 1% has been the norm. The categories in the CPI that have experienced the most significant price increases between September 2020 and September 2021 were transport, housing, water, electricity, gas and other fuels, alcohol, beverages and tobacco, restaurants and hotels, and communications. With the exception of the latter, these categories all made the greatest contribution to the rise in inflation. The figures I just quoted refer to headline inflation but core inflation, where we remove both unprocessed food and energy prices, has also risen although by less. It increased by 1.4% in July, 2.1% in August and 2.7% in September. Increases in price inflation across categories seem to suggest more broad-based inflation but I would suggest that we need more observations. On building costs, the wholesale price index for buildings and construction has been consistently increasing year on year since last March. Materials prices have increased from 2.3% in March 2021 to almost 13% in September.

The general consensus is that the current increase in inflation is temporary and that inflation will fall back towards the European Central Bank, ECB, target of 2% or below over the medium term. The Central Bank of Ireland is forecasting headline price inflation for Ireland of 2.1% in 2021 rising to 2.9% in 2022, which is above the ECB inflation target of 2%, but moving back to below that target at 1.9% in 2023. Recently the US Federal Reserve, the ECB and the Bank of England all projected a temporary effect although there are differences between them. The reasons for this temporary effect are various. First, energy prices are expected to stabilise or fall next year. Second, supply is expected to recover as supply disruptions ease and demand is expected to normalise. Third, base effects will drop out of the inflation figures. Underlying this is the view that long-term inflation expectations remain well anchored.

However, there are risks around these projections and the risk are mainly on the upside, that price inflation could be more persistent and therefore, higher than projected for next year and into the medium term. These centre around the restoration of global supply chains, global energy and commodity prices and wages. The recent supply chain disruptions are global in nature and have been directly or indirectly related to Covid. Companies are attempting to offset the effect of increased costs on their margins by increasing prices and generating efficiencies. The key uncertainty here is how long supply chains remain disrupted but even if they remain disrupted for longer, it is expected that impacts will still be transitory as companies and businesses move to re-establish reliable operations and cut costs in the chain, as they have done in the past.

The point is made that the pandemic has led to a series of regional supply and transportation disruptions, linked to the spread of Covid and the vaccination programmes, which may have had a more persistent impact than a single large shock. Even if disruptions continue, another uncertainty is to what degree companies will be willing to continue to pass these higher costs on to their customers.

On global energy costs, the projections are that prices for crude oil, gas and solid fuels will reverse in 2022, reducing headline price inflation. However, it is argued that uncertainty remains high and that imbalances could lead to spikes in prices. Oil prices, although high relative to pre-pandemic levels, are still well below their all-time high of 2008 and the subsequent peak in 2013 so they could move higher. Energy prices are also wrapped up in geopolitical issues. In addition, climate change targets are increasing the global demand for the bridging fuel, namely, natural gas. Turning to headline price inflation in Ireland, short-term increases arising from electricity price rises, effective from late October into November 2021, are still in the pipeline.

Another major uncertainty relates to wages and the level of slack in the labour market. On the one hand, we might expect upward pressure on wages if consumers reorient their spending back towards services, if there is a reduction in the size of the labour force or, indeed, in particular sectors and if higher inflation features in wage negotiations or causes an upward revision of inflation expectations. On the other hand, the ending of the pandemic supports could result in some loosening of the labour market which would put downward pressure on wages. There is significant uncertainty around this.

There are also questions regarding demand in 2022. It is expected demand pressures will subside as the pent-up demand unwinds but this will also depend on policy responses.

On policy responses, the appropriate response of a central bank to supply-side shocks is not as straightforward. Supply-side shocks such as energy prices rises may be temporary or transitory. Therefore, if the central bank increases interest rates today in response to this, by the time the impact of the policy change comes over the medium term energy prices may no longer be increasing or indeed may have reversed. By leaving well alone and not stepping on the brake the central bank does not aggravate the problem. Central banks will be concerned about whether these supply-side shocks will persist and will have persistent effects on the economy through second-round effects and then of course whether to act. The situation today is very complex. On the one hand, there has been a significant rebound in demand causing demand-pull inflation where demand has outstripped supply. On the other hand, there are major supply-side shocks around which there is major uncertainty. However, it is important to note that prior to the pandemic, price inflation has been persistently below its inflation target and that returning inflation to its target is the desired aim of central banks.

On fiscal policy, the situation, as stated earlier, is more complicated when supply-side shocks and as we are seeing today, supply chain and labour market disruptions, are the cause of costs and price increases. What governments can do is ensure they are not adding to the disruption. At the same time, governments may be able to reduce the impact of these supply shocks and increase efficiencies through infrastructure investment, for example. They may also be able to reduce labour mismatch through the provision of education and training, reducing both frictional and structural unemployment; in other words, by focusing on supply-side policies. The volatility introduced through dependence on fossil fuels also provides a further reason, in addition to climate change, for governments to focus on investment and incentives to reduce dependence on fossil fuels.

As a final point, it would appear the current increase in inflation is temporary, although there are caveats around this. This raises the question of whether inflation will revert to the inflation rates that existed prior to the pandemic, or to a higher rate of price inflation. The change in the ECB's monetary policy strategy with the restatement of the ECB's target for inflation of 2% may increase expectations of price inflation which will in turn affect actual inflation. Another possibility is the consequence of the recent price increases is price inflation may now re-enter people and workers' decision making processes. Other factors which may also affect the trend inflation rate, that is, the dynamics of inflation and volatility, are of course demographic considerations, globalisation and climate change.