It is now clear that intraday inflation will remain much higher for much longer than forecasts are predicting

On July 1, the CSO released unscheduled inflation statistics showing that the harmonized index of consumer prices (HICP – the EU’s most popular barometer of inflation) in Ireland had risen by 9.6 percent in the 12 months to the end of June.

Not only was Ireland’s HICP well above the EU average of 8.6 per cent, it was also well above the latest CPI figure, which showed price increases of 7.8 per cent in the country over the year to May.

In practice, HICP and CPI are practically identical. While the HICP excludes rental costs, the two tend to be very similar, with the HICP rising faster when prices start rising and then falling faster when they start falling.

For those of us left drunk at the checkout by soaring prices, the CSO announcement will have come as little surprise.

Regardless of what measure one uses 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 predicted. The ECB’s forecast of an inflation rate of 6.8 percent this year and only 2.8 percent in 2023 seems hopelessly optimistic to me.

Compare the current official interest rates with price developments. The ECB’s main refinancing rate has been 0 percent since 2019, while its top lending rate is just 0.25 percent, while it actually charges eurozone banks a 0.5 percent negative interest rate on deposits.

Although the ECB has signaled that it will hike interest rates by 0.25 percent this month, with more hikes planned for later in the year, official interest rates will still be a fraction of inflation’s rate.

Even after the recent increases, interest rates in the US and UK are much, much lower than inflation. The Fed’s main interest rate, the fed funds rate, is only 1.5 to 1.75 percent, while the Bank of England’s base rate is 1.25 percent.

When inflation is very low, which it was until recently, we all focus on the nominal interest rate. That makes sense if we don’t have to worry about inflation eroding the real value of our savings or credit. However, everything changes when inflation soars, as it is now.

Then we need to look at the real interest rate, which is the nominal interest rate minus inflation, and not the nominal interest rate. It quickly becomes clear that even after the ECB implements the forecast increases, real interest rates in the euro zone will not only be very low, but negative.

Even if the ECB’s inflation forecast for this year of 6.8 percent proves correct and it raises its refinancing rate by 0.25 percent this month and another 0.25 percent in September, it will still be at just 0.5 percent lie. This would mean that the real interest rate would be -6.3 percent (0.5 percent to 6.8 percent). If the inflation rate in the Eurozone stays at the current 8.6 percent, then the real interest rate would be -8.1 percent.


Inflation will remain much higher for much longer than central bankers and most economists predicted. Image from a photo agency

This is clearly a totally unsustainable situation going on for a very short period of time. Bond yields are already moving sharply higher. Over the past 12 months, 10-year German government bond yields have risen from a negative 0.22 percent to nearly 1.3 percent, while Irish government bond yields have risen from less than 0.1 percent to 1.88 percent over the same period.

The canary in the coal mine, however, has been Italian bond yields, which have more than quadrupled over the past 12 months from 0.75 percent to 3.4 percent.

Does this herald a new eurozone sovereign debt crisis, either later this year or early next? With the Irish government owing its creditors €242 billion, even a 1 percent increase in the average cost of borrowing would cost the Treasury an additional €2.4 billion a year. Finance Minister Paschal Donohoe will be watching closely.

Complicating matters further is the disentanglement of one-off factors like food and energy prices to arrive at a figure for “core” or underlying inflation, says Dermot O’Leary, chief economist at Goodbody Stockbrokers.

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

It is this core inflation rate, rather than the HICP, that the ECB will look to when making interest rate decisions.

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

Brent crude oil prices fell at times to just $100 a barrel, the lowest since Putin’s invasion of Ukraine, while grain and vegetable oil prices also fell sharply. If these commodity price declines continue, we could see inflationary pressures weakening and the gap between nominal and real interest rates narrowing.

But if they aren’t – UK natural gas prices have risen sharply in recent weeks – then the outlook is much bleaker.

“When it comes to interest rate expectations, the risk is to the upside,” says O’Leary. It is now clear that intraday inflation will remain much higher for much longer than forecasts are predicting

Fry Electronics Team

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