For much of the past year, we have been bombarded with talk of inflation.
It all started around this time last year as economies reopened following repeated coronavirus shutdowns and surplus economies began to be released.
As demand soared, economists warned of the potential for higher prices in economies as supply chains slowly got back into gear.
There were also what they called “base effects”.
As prices had fallen in 2020, there was an inevitable uptick as demand returned, leading to talk of inflation as temporary or “transitional”.
In other words, it would pass and although prices might end up being a bit higher, the inflationary environment would die down.
And besides, we hadn’t had much inflation in the last decade, so a dose of that wouldn’t hurt us.
Radically changed environment
Russia’s invasion of Ukraine radically changed the picture.
Oil and gas prices – which had already been the source of much of the energy price inflation – soared even higher.
Brent crude hit a 15-year high near $140 a barrel before pulling back, but has settled comfortably at around $120 a barrel now.
The transitory inflation theory now appears to be well and truly debunked, although European Central Bank chief economist Philip Lane said over the weekend that he was confident inflation would start to fall by by the end of the year and would return to its Target Range of 2% in future years.
Although talk of interest rate hikes in Europe has died down, some believe they are back on the agenda after the ECB announced plans to withdraw stimulus efforts sooner than expected.
The bank also lowered its growth forecast for the coming year.
With no sign of an imminent end to Russia’s war with Ukraine, talk turned to the possibility of a recession.
Along with inflation, that would precipitate what economists call “stagflation” – a particularly toxic mix of rising prices as economies contract.
The name is derived from its two main characteristics – simultaneous inflation and economic stagnation.
Generally, policy makers are unable to tackle one problem without making the other worse.
It’s a scenario we haven’t seen in decades and hope to avoid at all costs now.
What are the chances of a return to stagflation now?
Not at all likely, says the President of the European Central Bank.
Addressing a conference in Paris earlier in the week, Christine Lagarde said worst-case assessments did not foresee a recession in the euro zone.
“Even in the darkest scenario, with second-round effects, with a boycott of (Russian) gas and oil and an escalation of the long-running war – even in these scenarios we have a growth of 2, 3%,” Ms. Lagarde said. noted.
What is certain is that the central bank is walking on a monetary tightrope.
Although maintaining price stability is its primary objective, it must do so without harming economic activity.
However, the performance of the European economy is far from assured at present.
The global situation is so shrouded in uncertainty that the OECD said last week that it was “not in a position” to present its usual economic outlook.
He presented a simulation of some of the potential results of the war, as up to 1.5 percentage points could be erased from economic growth in the euro zone this year.
But some worry that this underestimates the true economic impact.
Economic growth in Ireland has rebounded strongly in 2021, with gross domestic product growing at a rate of over 13%.
There was a sharp decline in growth recorded in the last quarter of the year, which may be due to “statistical noise” rather than anything significant.
However, this is the largest quarter-over-quarter decline on record and has led to a year that is sure to present major economic challenges.
The Economic and Social Research Institute (ESRI) presented its updated outlook for 2022 during the week with GDP growth reduced from 7% to just over 6%.
A more accurate representation is Modified Domestic Demand which measures the growth of the national economy and largely eliminates the multinational effect which tends to skew our GDP numbers.
The institute sees this metric rising at a rate of 5% – up from just over 7% previously.
This is largely due to the reduced purchasing power of consumers adjusting to the rising cost of living.
In a monthly analysis of consumer sentiment, KBC Bank Ireland described the inflationary environment as representing a “radical change” in the situation of households after years of subdued inflation.
“Quantifying these pressures is made very difficult by the exceptional volatility in commodity prices at present, as this makes the precise rate of inflation likely to prevail through 2022 unusually uncertain,” said Austin Hughes, Chief Economist at KBC Bank Ireland.
Assuming an average inflation of 6% in 2022, he calculated that the acceleration in price increases between last year and this year would drain about 4 billion euros from consumer purchasing power in 2022 alone.
This implies an impact on the average household of just over €2,000.
Is a recession on the horizon?
Although all current outlooks are presented with significant caveats, Ireland should escape recession for this year at least.
“The resilience of the multinational sector and the adaptability of domestic businesses seen through the pandemic suggest Irish economic growth will slow rather than stall in 2022,” said Austin Hughes.
Dermot O’Leary, chief economist at Goodbody agrees that the prospect of a recession here is remote at this point.
“The closer you are to the conflict, the greater the impact. We are west of the continent. The second and most important factor is how quickly the economy enters this crisis,” he said. he explains.
However, he said basic domestic demand and disposable income – both very high before the invasion of Ukraine – would undoubtedly be hit.
Regarding the euro zone, he said the odds of the bloc tipping into recession had diminished, but certain assumptions had to be met.
“You would need to see an extended period of oil prices at $150 a barrel, for about six months. And that’s a prospect. The next steps for the Europeans will be to push for increased sanctions, and more,” said he explained.
Pressure on households and incomes
With inflation expected to peak at 8.5% by summer, ESRI predicts the rate of price increases will average just under 7% for the year.
While last year was largely confined to energy prices, the inflationary push has spread to other areas, with food in particular poised for steep increases as pressure on ingredients and processing costs are escalating.
The blow to households will be multifaceted.
For those lucky enough to be able to demand wage increases above the rate of inflation, they should be able to absorb the price increases without hurting their standard of living.
However, based on the revised inflation forecast, an employee would need to receive a salary increase of almost 10% this year to achieve this.
Any rate lower than the rate of inflation would effectively lead to a weakening of the purchasing power of a household.
Employers, who had pleaded for moderation on the grounds that inflation was transitory, will come under intense pressure from employees and their representatives.
“It will be very interesting to see what happens with public sector wage negotiations this summer,” said Stephen Kinsella, professor of economics at the University of Limerick.
“The unions will come back and seek wage increases based on inflation at 7 or 8 percent, for example, and they will seek 8 to 10 percent over three years, which will significantly increase the public wage bill,” he noted. .
And if that’s true for public sector unions, it will also be true for the private sector, especially in industries where the constraints are enormous like technology, pharmaceuticals and biotechnology.
For those on fixed incomes or in less competitive sectors where an employer is unwilling to pay up to 10% over one or two years, workers will indeed be poorer in real terms, Stephen Kinsella points out.
“These are the outcomes you want to avoid because you’ll push people out of the market,” he said.
“It could cause a recession if monetary and fiscal policy is incorrect at the same time,” he warned.
An election is not expected for a number of years, but the cost of living is already emerging as an issue that is likely to dominate the debate.
And that’s on top of the underlying affordability issues that already persist in the economy in the areas of health, housing and child care.
While they have been largely sidelined by Covid and now a war on the fringes of Europe, they have not gone away and will likely have been exacerbated by recent developments.