Inflation figures released by the Central Statistics Office yesterday reveal that Irish inflation hit a record high. Prices on average, as measured by the Consumer Price Index (CPI ), were 5.5 percent higher in December compared with December 2020. This is the largest annual change in prices since June 2001 when annual inflation was 5.3 percent. This increase in Irish inflation is mirrored in the euro area. The Harmonised Index of Consumer Prices (HICP ) – the European Central Bank’s (ECB ) preferred measurement of inflation - stood at 5 percent in December 2021 according to Eurostat’s flash estimate, which was the highest level recorded since the euro was introduced in 1999.
Rising inflation is not unique to the Euro area. UK inflation hit 4.8 percent in the twelve months to December 2021, prompting the Bank of England to raise its main interest rate to 0.25 percent from a historic low of 0.1 percent in December. US Consumer price inflation was 7 percent higher in December from a year earlier, the highest US inflation since 1982. The US central bank has pencilled in three 0.25 percent increases in interest rates this year.
Energy has been the prime factor behind the sharp rise in overall consumer price inflation. Between April and December 2021, energy made up more than half of euro area HICP inflation. In addition, economies have reopened rapidly after the COVID-19 lockdowns and this has put upward pressure on prices.
The ECB is mandated to deliver one objective and one objective only: price stability. This the bank defines as inflation stabilised at 2 percent over the medium term. The central bank has kept interest rates at historically low levels as inflation was struggling to reach its 2 percent target over the last number of years. Indeed, the ECB’s deposit facility has been negative since 2014, with banks like the AIB and Bank of Ireland having to pay the ECB to hold deposits with them. This was to incentivise banks to lend more to households and firms and boost inflation. AIB, Bank of Ireland and Ulster Bank have passed those negative rates onto business deposit holders with excess of €1 million in their accounts. So instead of being paid interest on your deposits, you are charged money instead.
So why aren’t the ECB following their counterparts and raising interest rates now that inflation is more than double its target?
Their view – so far – has been that these rises in energy prices are transitory and will not impact on inflation over the medium term. Increasing interest rates now would therefore be counterproductive. In other words, it would be 2023 or 2024 by the time an increase in interest rates today would show up in the inflation data. The oil price shock will have already faded, and higher interest rates today would exert unwanted downward pressure on inflation then. Therefore, the ECB has continuously suggested that there is no need to raise interest rates in 2022. This was reiterated by the President of the ECB, Christine Lagarde, at the ECB’s last Governing Council meeting in December.
What would make the ECB abandon their low interest rate policy? According to Isabel Schnabel, executive board member of the ECB, one reason is if consumer priceexpectations become ‘unanchored’. Inflationary expectations feed into actual inflation and so it is no surprise that they influence ECB thinking on future interest rates. Inflation expectations are especially influenced by changes in the prices of goods that we buy often, including energy and petrol.
Over the past year, consumer price expectations for the next twelve months have increased sharply. They reached their highest level since the euro was introduced in 1999 and have remained close to record highs since then. The fear is that these higher price expectations will feed into higher demands for wages and wage growth more generally which would further exacerbate rising inflation. However, Schnabel said on January 4th at the annual meeting of the American Finance Association that ‘So far, there are no signs of broader second-round effects. Wage growth and demands by unions remain comparatively moderate’. However, if this was to change, monetary policy would have to respond by rising interest rates. The ECB will be keeping a very close eye on this.
The ECB meet in Frankfurt early next month to discuss whether they should raise interest rates to combat inflation. The ECB is likely to maintain their low interest rate policy for another while yet. This will be good news for variable mortgage holders but bad news for savers. While most of us will be protected from negative interest rates on our hard-earned savings, those with over €1 million in deposits will face negative rates as early as May. They will have to pay the bank for keeping their money on deposit there.
Marie Finnegan is a lecturer in economics and programme director of the Bachelor of Business in Finance and Economics in the School of Business at GMIT
