Economic Letter: An Overview of Recent Inflation Developments in Ireland and the Euro Area

• Letter looks at the factors contributing to recent developments in inflation rates in Ireland and the euro area.
• Energy inflation has an outsized impact on inflation in Ireland and across the euro area. Supply bottlenecks related to the pandemic have added to inflation rates.
• Policymakers must be alert to signs of persistently high inflation rates, but balance this with the need to protect the economic recovery from Covid-19.

The Central Bank has today (22 November 2021) published an Economic Letter entitled “An Overview of Recent Inflation Developments” (PDF 630.96KB). Authored by David Byrne and Zivile Zekaite, the Letter outlines recent developments in inflation in Ireland and the euro area. It examines the factors contributing to current inflation rates and the implications of these developments for monetary policy.

The Letter notes that, prior to the onset of the Covid-19 pandemic in 2020, inflation rates had been persistently low in the euro area and beneath the European Central Bank’s target since the Global Financial Crisis. The pandemic had a further significant impact on inflation, with the annual rate of inflation both in Ireland and the euro area declining even into negative levels. Since the beginning of 2021 however, inflation levels have been increasing. Euro area inflation in October is estimated to be 4.1% and, in Ireland, 5.1%.

Looking at data for the euro area, energy inflation has increased rapidly since the start of the year and, as a result, has had an outsized impact on the current elevated rate of inflation. Drawing on the Harmonised Index of Consumer Prices (HICP), the Letter finds that energy accounted for about half of inflation in October 2021, despite accounting for only around 10% of the HICP basket. If energy prices are excluded, inflation in October 2021 in the euro area was around 2%.

In Ireland, the Letter finds that inflation dynamics are similar to those for the wider euro area, with higher energy inflation accounting for a large share of the overall inflation rate. However, relative to the euro area, the prices of services in the Irish HICP have increased by more and were up 4.6% in the year to October. By comparison, the prices of goods and food have increased by 1.8%. Services inflation was therefore the largest contributor to overall inflation in Ireland.

Contrasting this data with more long-term trends in inflation, the Letter points out that the two-year inflation rate from October 2019 to October 2021 was 3.8% in the euro area and 3.6% in Ireland. By comparison, two-year consumer price inflation in the US was 7.5% in October. Nevertheless, the Letter notes that Irish and euro area inflation has accelerated recently by this measure, and should be monitored.

The Letter also examines the factors contributing to these developments. It notes that, following the contraction in economic activity due to Covid-19, there was a strong recovery in 2021. This in turn has led to mismatches between demand and supply. Transport disruption and supply chain issues have contributed to sharp increases in the prices of commodities, raw materials, and other inputs in production. Price pressures have passed-through to consumer goods to some extent. An imbalance in supply and demand for services as sectors reopened has contributed to wage pressures in certain sectors.

Turning to the implications for monetary policy, the Letter notes that current ECB forecasts are for inflation to average 2.2% in 2021 – peaking in Q4 – before falling to 1.7% in 2022 and 1.5% in 2023. Central banks, including the ECB, expect the effects of energy prices and supply bottlenecks on inflation to reduce in the coming years. However, competing views suggest that the current high rate of inflation will lead to higher wage demands, and in turn prolong the elevated inflation rate. The Letter notes that there is a risk of inflation overshooting the current ECB target of 2% in a persistent way. Factors that might contribute to such a scenario include persisting disruption in supply chains and the ensuing impact on wages and inflation expectations. However, the Letter finds that this is not the most likely scenario currently.

The Letter concludes that monetary policymakers must be alert to signs of an unsustainable adjustment and be ready to act should this occur. However, it asserts the need for balance, lest an overreaction to price pressures that will eventually unwind adversely affect the economic recovery from Covid-19.

Note to Editors

Consumer price inflation in the euro area is measured by the Harmonised Index of Consumer Prices (HICP). The HICP tracks the prices of a large basket of consumer goods and services every month. This information allows the calculation of the rate of change of the prices of the items in the basket. By aggregating the various relative price changes, the HICP provides an overall measure of consumer price inflation.

The full series of Economic Letters can be found here.