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Wednesday, December 07, 2022

It is now clear that daily inflation will remain much higher for much longer than forecasts predict.

On July 1, the CSO released a set of unscheduled inflation statistics showing that the Harmonized Index of Consumer Prices (HICP, the EU’s favorite inflation barometer) had risen by 9.6% in Ireland over the 12 months until the end of June.

Not only was Ireland’s HICP significantly higher than the EU average of 8.6%, it was also well above the most recent consumer price index figures, which showed a 7.8% increase in prices in this country during the year until May.

In practice, the IPCA and the CPI are practically identical. Although the HICP excludes rental costs, the two tend to track each other very closely, as the HICP rises more quickly when prices start to rise and then falls more rapidly when they start to fall.

For those of us who have been inebriated by sky-high prices at the checkout, CSO’s announcement will have come as little surprise.

Regardless of which indicator is used to measure inflation, it is now as clear as daylight that inflation will remain much higher for much longer than central bankers and most economists had been predicting. The ECB’s forecast of an inflation rate of 6.8% this year and just 2.8% in 2023 seems hopelessly optimistic to me.

Compare current official interest rates with what is happening with prices. The ECB’s main refinancing rate has stood at 0pc since 2019, while its marginal lending rate is only 0.25pc, while it actually charges eurozone banks a negative interest rate of 0, 5 pc on deposits.

Although the ECB has signaled it will raise interest rates by 0.25 percent this month, with further hikes planned for later in the year, this will leave official interest rates at just a fraction of the rate of inflation.

Even after recent increases, US and UK interest rates are also much lower than the rate of inflation. The Fed’s main interest rate, the fed funds rate, is just 1.5%-1.75%, while the Bank of England’s base rate sits at 1.25%.

When inflation is very low, as it has been until recently, we all tend to focus on the nominal interest rate. That makes sense when we don’t have to worry about inflation eroding the real value of our savings or loans. However, everything changes when inflation spikes, as it is doing now.

So we need to look at the real interest rate, the nominal interest rate minus inflation, rather than the nominal interest rate. When we do, it quickly becomes clear that even after the ECB implements the planned hikes, real interest in the Eurozone will not only remain very low, it will be negative.

Even if the ECB’s 6.8% inflation forecast for this year turns out to be accurate and it raises its refinancing rate by 0.25% this month and another 0.25% in September, it will still be at just 0.5 %. This would mean that the real interest rate would be -6.3pc (0.5pc-6.8pc). If the eurozone inflation rate remains at the current 8.6%, the real interest rate would be -8.1%.

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Inflation will remain much higher for much longer than central bankers and most economists had predicted. stock image

This is clearly a completely unsustainable situation beyond the very short term. Bond yields are already moving sharply higher. Over the last 12 months, 10-year German government bond yields have gone from negative 0.22% to almost 1.3%, while Irish government bond yields have gone from below 0 .1% to 1.88% during the same period.

However, the canary in the coal mine has been Italian bond yields, which have more than quadrupled from 0.75% to 3.4% in the last 12 months.

Is this the harbinger of a new eurozone sovereign debt crisis later this year or early next? Given that the Irish state owes its creditors €242bn, even a 1% increase in average borrowing costs would cost the Treasury an additional €2.4bn a year. Finance Minister Paschal Donohoe will be watching this closely.

Further complicating matters is teasing out single factors like food and energy prices to arrive at a “core” or core inflation figure, says Goodbody Stockbrokers chief economist Dermot O’Leary.

In a presentation last month, the ECB’s chief economist, Philip Lane, put eurozone core inflation at just under 3%, still above the ECB’s target rate of 2%, but well below the target rate. current overall.

It is this core inflation rate, rather than the HICP, that the ECB will take into account when making interest rate decisions.

The ECB will have been encouraged by last week’s sharp falls in energy and food prices.

At one point, Brent crude prices fell to just $100 a barrel (€98), their lowest level since Putin’s invasion of Ukraine, while grain and vegetable oil prices also fell sharply. . If these declines in commodity prices continue, we could see a reduction in inflationary pressures and a narrowing of the gap between nominal and real interest rates.

But if they aren’t (UK natural gas prices have risen sharply in recent weeks), then the picture is much bleaker.

“When it comes to interest rate expectations, the risk is to the upside,” says O’Leary.

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