Costs climbing however is a recession on the playing cards too?

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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 after repeated coronavirus lockdowns, freeing up excess savings.

As demand surged, economists warned of the potential for price increases across economies as supply chains slowly get back on track.

There were also so-called “base effects”.

With prices plummeting throughout 2020, there was an inevitable rebound as demand returned, leading to talk of temporary or “temporary” inflation.

In other words, it would pass, and while prices might end up being a bit higher, the inflationary environment would abate.

Also, we haven’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 changed the picture dramatically.

Oil and gas prices – which had already fueled much of the energy price inflation – rose even further.

Brent crude hit a 15-year high of nearly $140 a barrel before declining but has now settled comfortably around $120 a barrel.

The theory of temporary inflation now appears to have been finally disproved, although the European Central Bank’s chief economist Philip Lane said this weekend he was confident inflation would start falling by the end of the year and return to its 2% target corridor in the coming years.

Although talk of rate hikes in Europe has died down, some believe it is back on the agenda after the ECB announced plans to withdraw its stimulus efforts sooner than expected.

The bank also lowered its growth forecast for the coming year.

With no signs of Russia’s war with Ukraine ending anytime soon, there is talk of the possibility of a recession.

Along with inflation, this would trigger what economists call “stagflation” — a particularly toxic mix of rising prices while economies shrink.

The name derives from its two main characteristics – simultaneous inflation and economic stagnation.

In general, policymakers are unable to address one problem without making the other worse.

It’s a scenario we haven’t seen in decades and that we now want to avoid at all costs.

The disco era – when “stagflation” was at its peak

What are the chances of a return to stagflation now?

Not at all likely, believes the President of the European Central Bank.

At a conference in Paris earlier this week, Christine Lagarde said worst-case valuations do not predict a recession in the euro zone.

“Even in the direst scenario with second-round effects, with a boycott of (Russian) gas and petrol and an intensification of the war that has been going on for a long time – even in these scenarios we have 2.3% growth,” Lagarde said.

What is certain is that the central bank is walking 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.

The global situation is so shrouded in uncertainty that the OECD said last week it was “unable” to present its usual economic outlook.

It presented a simulation of some potential war outcomes, potentially wiping out up to 1.5 percentage points of eurozone economic growth this year.

However, some are concerned that this underestimates the true economic impact.

What about Ireland?

Economic growth in Ireland rebounded strongly in 2021, with gross domestic product growing by over 13%.

The final quarter of the year saw a sharp slump in growth, which may be due to “statistical noise” rather than anything significant.

However, it was the sharpest quarterly decline on record, leading to a year that is bound to present some major economic challenges.

The Economic and Social Research Institute (ESRI) presented its updated outlook for 2022 later in the week, with GDP growth trimmed to just over 6% from 7%.

A more accurate representation is modified domestic demand, which measures domestic economic growth and largely hides the multinational effect that tends to skew our GDP numbers.

The institute expects this measure to expand at a rate of 5% – up from just over 7% previously.

Much of this is 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 a “fundamental change” in circumstances for households after years of subdued inflation.

“Quantifying such pressures is made very difficult by the current exceptional volatility in commodity prices, as this makes the precise rate of inflation that is likely to prevail into 2022 unusually uncertain,” said Austin Hughes, chief economist at KBC Bank Ireland.

Assuming average inflation of 6% in 2022, he calculated that the exacerbation of price increases between last year and this year would deprive consumers of around €4 billion in purchasing power in 2022 alone.

This means damage for the average household of just over €2,000.

Inflation, which until now has been largely confined to energy prices, is spreading to other areas such as food

Is a recession imminent?

Although all current prospects are heavily qualified, Ireland should escape recession for at least this year.

“The resilience of the multinational sector and the resilience of domestic companies seen through the pandemic suggest that Irish economic growth is likely to slow rather than stop in 2022,” said Austin Hughes.

Goodbody chief economist Dermot O’Leary agrees that the prospect of a recession here is far-fetched at this point.

“The closer you are to the conflict, the greater the impact. We are in the west of the continent. The second, more important factor is the speed with which the economy is entering this crisis,” he explained.

However, he said domestic demand and disposable income – both very high before the invasion of Ukraine – would undoubtedly take a hit.

Speaking about the eurozone, he said the probability of the bloc sliding into recession has fallen but there are certain assumptions that need to be met.

“You would need to see a sustained period of oil prices around $150 a barrel for about six months. And that’s a prospect. Europeans’ next steps will be to push for increased sanctions. You could see energy prices go up to $150 plus then,” he explained.

Pressure on households and income

With inflation expected to peak at 8.5% by summer, ESRI expects inflation to average just under 7% for the year.

While largely confined to energy prices last year, the inflationary spurt has spread to other areas, with food in particular poised for sharp price increases as pressures on ingredients and processing costs mount.

The impact on households will be multifaceted.

Those lucky enough to be able to demand wage increases in excess of inflation should be able to absorb the price increases without hurting their standard of living.

However, based on the revised inflation projections, a worker would need to receive a pay rise in the region of almost 10% this year to achieve that.

Anything below the inflation rate would effectively weaken a household’s purchasing power.

Employers, who had called for restraint due to temporary inflation, are coming under heavy pressure from workers and their representatives.

“It will be very interesting to see what happens with public sector wage negotiations over the summer,” said Stephen Kinsella, professor of economics at the University of Limerick.

“The unions will come back and seek pay rises based on say 7% or 8% inflation, and they will target 8% to 10% over three years, which will increase the public wage bill enormously,” he noted.

And what is true of public sector unions is also true of the private sector, particularly in industries with severe constraints such as technology, pharmaceuticals and biotechnology.

For workers on a fixed income or in less competitive sectors where an employer is unwilling to pay up to 10% over a year or two, workers will effectively be poorer, Stephen Kinsella points out.

“It’s those outcomes that you want to avoid because you’re going to put people out of the market,” he said.

“It could trigger a recession if monetary and fiscal policies are wrong at the same time,” he warned.

An election is years away, but the cost of living is already emerging as an issue likely to dominate the debate.

And that’s on top of the basic affordability problems in health, housing and childcare that already exist in the economy.

Although largely brushed aside by Covid and now a war on the fringes of Europe, they have not gone away and are likely to have been exacerbated by recent developments.