Inflation and monetary policy: what to expect

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This week’s news on falling inflation in May was welcome.  Across the euro area, inflation is now at 6.1 per cent, down from a peak of 10.6 per cent in October 2022.  And in Ireland it is now down to 5.4 per cent according to the flash estimate released by the CSO on Wednesday, down from 9.6 per cent last summer. 

However, as we all know, one swallow does not make a summer.  Although the fall in inflation is welcome, this week’s data does not confirm that monetary policy has reached the ‘top of the ladder’ as it aims to deliver price stability and an inflation target of 2 per cent in the medium term.

I want to use today’s blog to write about inflation in the euro area and the decisions my colleagues on the ECB’s Governing Council and I have taken to address it.

When everybody pays more and gets less for it, it can have some serious, if not devastating, effects on the economy.  The longer inflation persists, the greater the damage. Inflation hits some harder than others, but everyone in society is going to be further impacted if high inflation persists. That is why the fight against inflation is well underway: we want it to return to our target.

The inflation surge has eased, but there is more work to do

The euro area is facing an extraordinary inflationary episode in terms of its scale and persistence.  We know that this inflation is a global phenomenon that was driven first by supply shortages coming out of the pandemic and then continued with the onset of Russia’s war.  These overlapping shocks fed inflationary pressures, at least initially. While we have seen some cooling in price pressures, we are still seeing strong underlying price pressures, also now driven by demand, and we are seeing them rise in a broad range of products and services.

We want low, stable and predictable inflation and we clearly aren’t there at the moment.

I should add that, while we see the rate of inflation – that is, the rate of change in the price level - coming down, it does not automatically mean that price levels will also decline.  Prices in Ireland are now substantially higher than before the pandemic and Russia’s invasion, most notably for energy (+57 and +30 per cent compared to February 2020 and January 2022, respectively) and food (+16 per cent and +12 per cent, respectively). 

Inflation started to move up beyond 2 per cent during the summer of 2021 as lockdowns were lifted.  We saw another jump in March 2022 and, at that point, it was mainly energy prices – reflecting global forces – that were driving the increase. Energy inflation stayed high until relatively recently but has started to come down since the beginning of the year.  In fact, since March its contribution to overall inflation has been close to zero.

Yesterday, I met with local community and business representatives in Mayo who discussed the very real cost-of-living increases they are currently seeing. With some energy related prices coming down, food inflation has been playing a more prominent role, accounting for almost a third of overall, or ‘headline’ inflation in Ireland, and even more in the euro area.

Meanwhile, services inflation has picked up, which is a key driver of underlying, or core inflation (that is where volatile components such as food and energy are stripped out). In services, we see some secondary impacts from higher food input prices: food services inflation, that is, what we spend on food and drink outside of the home, accounts for 2 per cent of the 4.1 per cent annual services inflation recorded in Ireland in April 2023 (broadly similarly to the euro area) with the next largest being rent, at 1.4 per cent of the total (4.1 per cent).  This is one area where we do stand out from the rest of the euro area: rent increases in the euro area in April accounted for just 0.3 per cent out of 5.2 per cent total services inflation.

As well as the continued pass-through of external commodity price shocks, strong domestic demand for goods and services is a factor in underlying inflation. 

The level of demand in the economy is also being influenced by the very tight labour market and fiscal policy action.  

A tight labour market and wage catch-up as a result of the recent surge in inflation is expected to contribute to strong wage growth both this year and next.  However, rising wages will only partly offset the loss of purchasing power that many households are experiencing as a result of high inflation.  Furthermore, catch-up is gradual, with real wages (i.e., after inflation) only expected to return to 2019 levels in 2024. If households and firms come to believe that inflation will remain high indefinitely, it would influence forward-looking price and wage setting behaviour. In monetary policy circles we refer to this as a ‘dis-anchoring of inflation expectations’, and, were it to happen, it would make the task of reducing inflation far more difficult. One of the reasons central banks’ policy rates are rising across the world is to prevent this happening.

Monetary policy: tempering demand and inflation expectations

Monetary policy fights inflation mostly through two channels: first, by reducing aggregate demand, and second, by anchoring the expectation of future inflation to its target.

Monetary policy can do little to address supply constraints but, by increasing interest rates, it can cool demand and help bring inflation down.

The transmission from policy rates to inflation works its way through the financial system via many channels into economic activity, with some degree of uncertainty about the timing and size of the impacts. For a small, open economy like Ireland, external demand (i.e., from abroad) for good and services produced by firms in Ireland is a key factor. Therefore, when we look at the impact of monetary policy on economic activity – in both Ireland and the euro area – we also pay close attention to global economic growth developments.

An increase in ECB interest rates affects financial markets via money-market interest rates, interest rates on assets, people’s expectations of interest rates in the future and the exchange rate. This is the first phase of the monetary policy transmission process, impacting financing conditions.

One important element of the transmission mechanism is the bank lending channel, where market rates transmit to lending rates making borrowing for firms and households more expensive and saving more attractive.

The ‘second phase’ of transmission is when changes in financing conditions start to impact households’ and businesses’ spending decisions.  Historical evidence, along with survey data, suggests that these effects start to kick-in around 12 months from the start of a rate-increase cycle, and permeate through economic activity for several years (often referred to as the ‘long and variable lag’ of monetary policy). The practical upshot is that it requires monetary policy to be set with a view to the future inflation outlook, and not just solely current inflation.  This also explains why the ECB focuses on a 2 per cent inflation target in the medium term; it wouldn’t be possible to target 2 per cent at all times.  

Current monetary policy interest rates…

Given the high inflation globally, the ECB along with most other central banks, has responded by raising interest rates. The scale and pace of the ECB’s interest rate increases is unprecedented (up 3.75 percentage points in just eleven months; for comparison, the rate-increase cycle in the euro area in 2005-7 saw rates rise by 2 percentage points over a 21 month period). These interest rates rises represent a significant tightening of the monetary policy stance, reflecting the major challenges to price stability we have been facing.

Monetary policy transmission is advancing…

The transmission of monetary policy into financial conditions is happening, although the pass-through of policy rates so far has not been uniform across the euro area. Interest rates on loans to firms and households increased sharply since the beginning of 2022. The cost of borrowing for euro area households was 3.5 per cent in March, up from 1.3 per cent at the same time last year.  For businesses, the cost of borrowing rose from 1.4 per cent to over 4 per cent over the same period.

In Ireland, we have seen slower pass-through than other countries, relative to what we would expect for mortgage lending and deposit rates.  Analysis by Central Bank staff has also shown that a larger proportion of fixed-rate mortgages slows pass-through. About 60 per cent of mortgage holders in Ireland are insulated from rate rises until the end of this year (given the nature of the mortgage product they have). Around one-third of these borrowers will need to refinance during 2024, when their fixed term expires.

In some countries, including Ireland, deposit rate pass-through appears to be sluggish so far. While it is too early to make a complete assessment, it is likely that the large volume of savings accrued by households during the pandemic are playing a role.

It is also worth noting that, given the very high savings rate of the Irish household sector – estimated at over 22 per cent at the end of 2022 by the CSO, compared to a historical rate of around 10 per cent – deposit rates do not appear to be a decisive factor in household saving decisions in Ireland.

The ECB, or indeed the Central Bank of Ireland, does not have a role in setting commercial rates on bank products but it is something we will monitor closely to assess the extent to which the intended monetary policy measures are transmitting to the Irish financial system.

Meanwhile, lending volumes have also started to decline. This shows that the first part of the transmission mechanism is working. It will take some more time, however, for the interest rate rises to feed through to domestic demand and inflation, and careful analysis will be needed to track its progress through the economy, including taking account of external demand.

The path ahead for monetary policy is conditional…

The path ahead for monetary policy remains conditional on the economic outlook. Central banks, through their monetary policies, can curb inflation, but of course this is not costless. However, history has taught us that letting inflation run its course has substantially higher costs for society. Last month we reiterated our monetary policy decisions will depend on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission.

It is essential that we take action to fight inflation. We have been making progress since December 2021 (when we first signalled our intent to normalise monetary policy) but the full effects of our tightening are still ahead of us. In saying that, however, and given our current outlook for inflation, we are likely to be closer to ‘the top of the ladder’ in terms of the interest rate cycle. The calibration of monetary policy from here has to remain data dependent given prevailing uncertainties.

How can the most vulnerable can be supported without adding to inflation?

Given the adverse impact that persistently high inflation can cause to the financial resilience of households and the wider economy, the monetary policy response that aims to bring inflation back to 2 per cent is clearly justified.

At the same time, the scale of the cost of living shock also justified fiscal supports to households and businesses by governments across the euro area, including Ireland.

But when inflation is already far too high, expansive fiscal policy risks undermining monetary policy, primarily by increasing aggregate demand but also by signalling that the government is counteracting the effects of policies aimed at reducing inflation, potentially increasing inflation expectations. This is why I and others have previously called for cost of living supports to be targeted (at those that need them most), temporary (to avoid adding to medium-term inflationary pressures) and tailored (to the specific challenge facing households and businesses).

The introduction and withdrawal of such measures impacts the path for inflation and the importance of the overall stance of domestic fiscal policy is something I will be reflecting on in my advice to the Government on framing policy over the medium-term, most immediately in Budget 2024.

It is of course important that, while meeting the appropriate underlying balance between spending and revenue in the years ahead, governments across the euro area, including in Ireland, prioritise supporting the most vulnerable.  But, with the underlying strength of demand conditions in the economy as a whole, now is not the time for the overall fiscal position to be adding more money into the economy (through government spending) than it is taking out through government revenues. If fiscal policy adds to aggregate demand in the economy, then monetary policy will have to work harder to bring inflation back to target.  

Conclusion

High inflation imposes enormous costs on our society. History has shown that the costs of bringing down inflation are likely to increase if monetary policy action is weak or delayed. A period of restrictive monetary policy is now needed to stem inflation and return it to its 2 per cent target in the medium term. Fiscal policy can and should help by avoiding boosting aggregate demand, holding back supply, or raising prices and, of course, by supporting structural reform to meet the challenges of the economic transitions (climate change, ageing society, in particular) that our communities are facing.

Finally, having started this blog with a reference to this week’s inflation data, let me end it with a reference to today’s news on headline GDP. What we see in the national account data released today is another clear example of the dual nature of the Irish economy, with some volatility in headline GDP driven by developments in multinational activity both within and outside of Ireland. The modified domestic demand numbers along with other economic data we have seen in the last few weeks, including with unemployment at historic lows, job vacancy rates remaining relatively high and growth in the domestic economy remaining relatively robust but with obvious constraints across various sectors, points to the economy at operating at capacity. We will say more about this when we publish our next Quarterly Bulletin in a few weeks.

Gabriel Makhlouf

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