The latest Irish Consumer Price Index, released by the Central Statistics Office (CSO) showed that prices were up 0.3% in the month in June but down 0.4% in the year. This was a slight improvement on the negative inflation rate of -0.5% posted in May, which was the lowest annual inflation rate since April 2015. With three consecutive months of negative annual readings, a question will now be asked as to whether we are heading into a period of deflation.
Of course, as with most economic releases during the Covid-19 crisis, there has through no fault of the CSO in these difficult times, been an issue as regards the overall quality of the data.
Due to COVID-19 restrictions, there continued to be unprecedented changes in household consumption patterns during June. It was estimated that households, on average, were unable to consume 25.5% of the goods and services in the CPI basket. This is the same figure as the previous month. These mainly consisted of the following items included in the CPI:
- Air transport, package holidays
- Restaurants, pubs and hotels
- Creches, pre-schools
- Hairdressers, health and beauty services etc.
- Recreational and sporting activities, cinema, theatre, etc.
- Wedding services
In addition to this, due to the closure of non-essential retail outlets, household consumption for many other goods and services was significantly reduced.
In total, 26.1% of the CPI basket required imputation for June because of the pandemic. This comprised 25.5% of the basket where consumption had ceased and 0.7% where it was not possible to collect prices.
Meanwhile, the most recent figures for the Eurozone as a whole showed an annual inflation rate of 0.3% in June, up from just 0.1% in May, which was the lowest level since June 2016. Despite the pick-up in inflation last month, it remains way below the European Central Bank’s target of just under 2.0%.
The latest economic forecasts from the ECB staff suggest inflation is likely to remain below target for some time, implying that official interest rates will stay extremely low for the foreseeable future. The ECB is looking for an average inflation rate of just 0.3% in 2020, picking up to 0.8% in 2021 and 1.3% in 2022.
Despite the huge level of stimulus (both monetary and fiscal) injected into the Euroland economy, the feeling within the ECB is that consumer demand will remain subdued in the short-term at least due in main to higher unemployment and households being less well off, both in monetary terms and confidence terms because of the pandemic. Oil prices too are likely to remain low, putting downward pressure on headline inflation. Against that, supply chain issues should increase the prices for some goods.
There is also the risk that some businesses will have no choice but to increase prices to compensate for the losses of income incurred as a result of the new health and safety measures they have to implement in the “new world” environment. As such, I believe, all things considered, inflation is more likely than deflation over the next few years. And although not my base view, I wouldn’t entirely dismiss the opinions of those who believe we could be headed for a period of stagflation.
But even if inflation in the Eurozone picks up quicker than the ECB is assuming, that may not necessarily mean higher interest rates. At least that is one of the things I took away from an IIEA webinar in Dublin last month, which was hosted by former Irish Central Bank Governor and ECB Governing Council member Patrick Honohan, and where the guest speaker was current ECB Vice-President Luis de Guindos.
There was a definite suggestion that the ECB could allow itself the freedom of letting its inflation target overrun in some years to offset it undershooting in other years so that over a 10-year period say, the average would be very close to 2.0%.
I wouldn’t rule out either the ECB following in the footsteps of the Bank of Japan and adopting a “yield curve control” strategy, which would keep the key 10-year bond rate depressed. At this juncture, nothing can be ruled in or out as to what exact measures the European Central Bank will use going forward to play its part in ensuring economic stability in the bloc.
Although price stability is the main mandate of the ECB, there is clearly a worry among some members about the underlying health of the region’s banks, and ultra-low interest rates do not help the profitability of these financial institutions.
But when push comes to shove, the impression I get is that the ECB will be willing to tolerate lower interest rates for longer even if inflation does surprise to the upside.
While borrowers might welcome the idea of higher inflation, not everybody will as it is traditionally the main enemy of the bond markets.
So, whether market rates (bond yields) would be so accommodating to a pick-up in inflation is another matter entirely, but as long as the ECB is willing to have substantial skin in the game, then bond yields should in my view remain very low for a prolonged period.
As things currently stand, the biggest risk to yields over the next few years is more likely to be geopolitical rather than economic, with “Brexit“, EU/US relations and whether the EU/Eurozone can hold itself together in the medium to long-term, the key drivers.
Author: Alan McQuaid is a leading economist and media commentator in Ireland. He has worked with the Department of Finance and the leading Irish stockbroking companies.