Oireachtas Joint and Select Committees

Wednesday, 10 November 2021

Committee on Budgetary Oversight

Inflation: Discussion

Professor Karl Whelan:

I thank the Chairman. Let me start with some of the facts. I am going to repeat quite a number of the things Dr. Kavanagh said and want to get on with it and not waste too much of the committee's time.

After many years out of the news, inflation has come to the fore again in recent months. We have seen that with a spike in inflation all across Europe. In Ireland, consumer price inflation as measured by year-over-year percentage change in prices in September was 3.7%. That is the highest reading since the period before the global financial crisis. The Central Statistics Office, CSO, has not yet published its figure for the October CPI, but EUROSTAT has a flash release for the harmonised index of consumer prices, HICP, which gives an estimate of what it thinks this number is going to be, or what inflation is going to do, in October. That showed a further of 1.3% rise in inflation in Ireland in October so we appear to be on track for an inflation reading of about 5% for year-over-year inflation to be published by the CSO very soon. This would be strikingly high relative to what we have seen in recent years.

The largest single contributor to the rise in inflation has been the jump in energy prices. The story on this has been relatively simple. The onset of the pandemic saw a collapse in energy prices. Most notably, oil prices fell because lockdowns meant people were not travelling in their cars, on aeroplanes and so on. As the global economy has recovered those initial price declines started to be reversed and with strong global demand for manufacturing we have seen those energy prices go back above the levels they were at prior to the pandemic. Even excluding energy, CPI inflation in Ireland was running at 2.5% as of September. That is very moderate. We know the ECB's target rate of inflation is 2% so there is nothing too scary about 2.5% but that is much higher than we had seen in the years running up to the pandemic.

There are a number of forces contributing to the rise in non-energy inflation. One element is we are seeing year-over-year price rises for services that were restricted in their activities for much of 2020. With the September CPI inflation reading, of that 2.5% for non-energy inflation, about 0.5% of it was things like air fares, hotels and restaurants, which were barely open a year ago. If they were open, they were offering cheap prices. Beyond that, we are seeing rising prices for industrial goods also contributing to inflation. This is basically a global phenomenon. The pandemic produced some quite unusual combinations of supply and demand for various products. On the supply side, we saw factory shutdowns in various parts of the world due to Covid outbreaks and we are still seeing elements of Covid outbreaks causing difficulties for manufacturing in various parts of the world.

The pandemic also produced unexpected changes in global spending patterns. With many service providers closed and limited opportunities for in-person shopping during lockdowns, households in advanced economies switched to purchasing goods online, most notably gadgets of various sorts. Much of that stuff is produced in Asia and especially China. That surge in demand for those products took those manufacturers by surprise and took transportation firms by surprise. If we take shipping for instance, prior to the pandemic there was the outbreak of a trade war between the US and China and that convinced many people global long-distance trade was actually going to decline during these years. We saw the supply of container shipping capacity was not able to cope with this surge in demand. Thus we have seen a big increase in shipping costs around the world and that has added to the cost of the goods we are buying. We are also seeing shortages of parts.

The other element influencing global inflation is surprisingly strong global demand.

Some farms and households have been badly affected by losing income because of shutdowns but, on average, the aggressive response from governments has meant that the average household balance sheet is stronger than it was 20 months ago. Consumers have spent less and active fiscal policies like wage subsidy schemes and the pandemic unemployment programme have meant that the direct impact on the average person's disposable income has largely been shielded. In addition, we have seen house prices continue to rise around the world and global stock markets are at an all-time high so people's ability and capacity to spend money on goods is strong.

What will inflation do next? One can provide an optimistic case and a pessimistic one. I will give members both cases and then we can discuss the arguments over questions. The positive case rests on observing that the recent high inflation rates are partly a function of what economists call "base effects". What do we mean by that? We had this period after the pandemic started in which prices were falling fast. Once it was clear that vaccines were going to come into place and that there would be an element of economic recovery, those price drops reversed.

The overall amount of inflation we have seen going back to the start of the pandemic is relatively modest. Prices in Ireland in September were exactly what they would have been if they had grown at an annual rate of 2% from the start of the pandemic, which is the ECB's target. On the path of how they have reached that level, we see there is an issue of sharp decline and now, when we are looking at figures for October 2020 versus October 2021, for which figures will be released next week, we will see that October 2020 was the bottom of the decline. That is the base that goes into the calculation of the inflation rate for that period. The idea is that as we proceed through the following months and into next year, we will not be comparing current prices with that particular artificial lull of the price level. That is the underlying assumption.

That is not to say that October has to be the peak. As Dr. Kavanagh pointed out, there is a process of the pass-through from wholesale to retail energy prices. That will go on over the coming months and continue to add to CPI inflation. It is unclear when the peak will be according to this scenario. The optimistic scenario is that these are just temporary numbers and base effects and we will largely see them go away. That is the scenario one can see in the economic projections accompanying the budget. The Government expects all prices to fall back a bit from their current levels and total and core inflation to be equal to the magic number of 2% in 2022 and beyond.

What are the risks on the high side? One obvious source of risk is that wholesale energy prices do not behave themselves. There are a lot of stories about the natural gas market, in Europe in particular, showing that it is under a lot of strain. What will happen with gas price developments in the coming months is likely to depend on factors such as the severity of the winter weather in Europe. It may depend on Russia's willingness to supply more gas to Europe in the absence of the complex issue of the Nord Stream 2 tunnel and whether it will get approval for quick usage or not. We also do not have a good handle on when the kind of global bottlenecks and mismatches between supply and demand that we are seeing will be resolved. We hope they get resolved quickly. To give one concrete example, we know it takes about three years from ordering a container ship to getting it delivered. There is a shortage and tightness in the shipping market, which will be in place for some time to come.

The argument that it is just base effects and that everything will normalise in the coming months is undermined by the fact that the core CPI, as Dr. Kavanagh has pointed out, has grown at quite a fast pace in recent months. Going beyond the coming months, we then start to get into the risk that in Ireland and beyond, these high inflation rates will start to fuel the public's expectations of what inflation will be. We might start to see trade unions looking for higher wages. Inflation could then get into the system in the way it did in the 1970s and 1980s and we would have a high inflationary wage-price spiral. Neither professional economists nor people in financial markets who have real money at stake are anticipating this high inflation scenario but it is worth pointing out the risks.

Since this is the Committee on Budgetary Oversight, I will talk a little about the budget and possible policy reactions. It is important to stress that Ireland imports a high fraction of the items that consumers purchase and in general Irish Governments have traditionally not had much control over inflation. There were not many tools available to the Government in the most recent budget that could offset this kind of largely externally driven inflation that we are seeing. What we saw in the budget were a number of measures such as adjustment of tax bands and increases in fuel allowances that at least partially offset the impact of the higher inflation on people.

The most obvious fiscal policy response is for the Government to consider temporary reductions in VAT rates on certain types of goods and services. That is a way to reduce the headline inflation rate. On balance, I would argue against that because it is politically difficult. We have seen examples of temporary low tax rates being introduced and they generally remain in place beyond the supposedly temporary period for which they were intended. It is a good thing that the budget did not proceed with various proposals that have been knocking around such as vouchers for the hospitality sector or other measures that would boost domestic demand and fan the flames of what is already an uncomfortably high level of inflation. In the longer term, in managing the demand and supply mix in the economy the Government has an ambitious capital spending plan. However, it will have to think about what the capacity of the economy is to deliver on that. If inflation has already moved up because of various global factors, overheating the domestic economy could just end up making a bad situation considerably worse.

It is easy to think of the negatives of a period of higher inflation on the budgetary position. It places upward pressure on Government spending on wage increases for the public sector and to adjust welfare rates upwards. It also generally brings in extra revenue and the Government will see extra VAT and corporate tax revenue. It will also see extra income tax revenue if people are getting wage increases to compensate them. On balance, the overall effect on the budget and the deficit as a share of GDP depends on decisions the Government takes but is likely to wash out in a neutral way.

A greater risk stems from the potential responses of central banks. A sustained increase in inflation, where it goes above 2% and stays there for a reasonable period of time, would likely see the end of the ECB's accommodative monetary policy and it would be likely to start to raise interest rates. That would have a fiscal effect because it would increase the costs of Ireland's government debt, which is still high when measured in per capitaterms. That said, the public debt has largely been financed via long-term and fixed-rate bonds and loans. The majority of the public debt does not mature until 2030 and has been locked down at low interest rates. It would take quite a while for those higher interest rates to have a big fiscal effect. More worrying is the possibility that the interest rate hikes that a sustained period of high inflation could produce from the ECB, the US Federal Reserve and possibly the Bank of England could lead to another global recession of the style we saw in the 1980s, 1990s and so on when central banks intervened and deliberately restrained the economy to bring inflation down.

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