Over the past couple of years, the sudden sharp surge in inflation and the resultant response from global central banks has been the dominant theme in the world of economics.
After a couple of decades of the ‘great moderation’, the sudden escalation in prices came as quite a shock to everybody and naturally central bankers responded in the only way they know, by increasing interest rates.
I have had deep reservations in relation to the aggressive response by the ECB.
I am not convinced that given the nature of the inflation shock, the magnitude of the interest rate increases delivered was necessary or indeed appropriate.
The surge in inflation was due to supply side issues that began with the covid crisis and was then exacerbated by the Russian invasion of Ukraine.
Food and energy prices were the obvious casualties of these events, and this then resulted in a more widespread escalation in prices.
It was certainly not the case that inflation in the eurozone was driven by excessive demand, and in fact the eurozone has been characterised by tepid demand for some time.
If demand is too strong, then increasing interest rates is the most appropriate response, but it is not clear that this is the best response to a supply-side driven escalation in prices.
The one thing that can be said in the ECB’s favour is that the monetary authority clearly set out to anchor inflation expectations.
In other words, by sending a strong message that it would do whatever it needed to do to control inflation, it sought to influence the behaviour of economic agents and prevent an inflationary psychology from taking hold.
The good news is that the battle against inflation, at least in Europe, has clearly been won and in fact disinflation is now starting to come back into focus.
The annual rate of inflation eased to 1.7% in the eurozone.
The ECB has now delivered three quarter percent rate cuts since June.
However, the aggressive approach of the monetary authority may just reflect a realisation that it tightened too aggressively and has responded too slowly to obvious signs of deep economic weakness in the eurozone, with Germany a particular growth laggard.
The good news for Irish borrowers is that the ECB easing will continue, and it is now possible rates could come down by another 1.5% over the coming months.
While the rate cuts already delivered and those yet to come will help Irish mortgage holders, one must be concerned about the impact on the housing market.
Over the past week, we got the latest reading on house prices from the CSO for August.
The annual rate of inflation at a national level has jumped to 10.1%; to 10.8% in Dublin; and to 9.6% outside of Dublin.
National house prices are now 13.7% above their unsustainable peak in April 2007; Dublin prices are 1.8% above their even more unsustainable peak in February 2007; and outside of Dublin prices are 14% above their peak in May 2007.
That the sort of house price growth we have seen over the past couple of years occurred in an environment where interest rates were tightened so aggressively is a worrying sign about the state of the market.
The risk now of course is that with the interest rate cycle on the way back down, house price inflation could accelerate even further.
This would not represent good news as it is not clear to me that rapidly rising house prices is an ‘economic good’, and in fact, I firmly believe it is an ‘economic bad’.
Increasing supply more aggressively is really all we can do, but even that would not guarantee a more stable house price environment.
Housing is a major dilemma in this country, just as it is in many other countries around the world now.