Dr. Cassidy and I welcome the opportunity to appear before the committee today to discuss the important topic of inflation. Last year, inflation was very subdued across the euro area - even turning negative for several months as economies closed down to slow the spread of the virus. Coinciding with the easing of health restrictions and increased economic activity, inflation turned positive again in 2021. We know that many people are feeling these very real price increases, in particular across their energy and fuel bills.
Overall, increasing inflation is being driven by three factors, namely, higher energy prices, a rebound in prices for some goods and services that fell sharply during the pandemic and a rebound in demand, which is meeting global supply bottlenecks in both inputs and transportation. At first, inflation developments in Ireland lagged behind those of the euro area due in part to a slower phased re-opening of the economy but in general, they have followed global trends over the past couple of years. Increases in global energy prices have been a major driver of inflation in recent months with inflation reaching 5.1% in Ireland in October and 4.1% in the euro area on a year-on-year basis. Energy prices have both a direct and indirect effect on prices people have to pay for goods and services. The direct effects on home heating or electricity and personal transport fuels - driven in particular by changes in energy prices in international energy markets - tend to pass through quickly to consumers. Indirect effects occur via the impact on business costs and tend to be passed on more slowly and only partly to consumers.
The rise in energy price inflation during the first half of 2021 follows on from the fall in prices in 2020 at the onset of the pandemic, that is, the so-called "base effects". Given that the prices of some goods and services fell during 2020 as governments imposed lockdowns, comparing prices from now - when economies have reopened - to last year can produce a sharp increase in measured inflation even if prices are recovering to pre-pandemic levels. These base effects were larger for Ireland compared with some other euro area countries simply because prices fell by more in 2020 in Ireland. However, these base effects are playing a smaller role more recently with energy price levels now exceeding those before the pandemic. While highly volatile and often influenced by geopolitical factors, market expectations are for wholesale energy prices to plateau in 2022 before declining gradually.
As well as energy prices, there are three other components of the Irish inflation index that are important to consider, namely, food, non-energy industrial goods and services. Increases in food and goods inflation reflect the global factors I have already mentioned, namely, global supply and transport bottlenecks. Pass-through from higher energy and input costs is also a factor and will likely continue to be so for several months yet.
However, the price of services in Ireland has been increasing through the second half of 2021. Within the services category, price increases in rents, restaurants and hotels stand out. This is not only for the scale of the increases but also because both categories together account for almost half of all services spending. Base effects are also relevant in these categories. Relative to pre-pandemic levels, rents and restaurant and hotel prices are both 4.2% higher according to the Central Statistics Office, CSO.
While measures of inflation are designed to represent an average consumption basket in an economy, people feel the impact of inflation differently and not everyone in the community will experience price increases in the same way. Some people will be more or less impacted by the recent bout of inflation simply because they are more or less exposed to certain price changes. Lower-income households, older people and rural households are more affected by energy-driven inflation. This is because it represents a larger proportion of their spending compared to other groups. Conversely, higher-income households, younger people and more urban households tend to spend more on services.
In deciding how to respond to inflation developments, monetary policymakers such as me need to consider two things. First, what is the source of the inflation and how long is it expected to last? Second, what is the potential for more broad-based and persistent inflation above the 2% target in the medium term? Forecasting future economic developments is always challenging but there is a remarkable level of additional uncertainty and complexity to consider right now. We are not in an ordinary economic environment.
Our judgment today is that we expect the global drivers of current inflation to recede gradually during 2022. On the potential for relative price changes to lead to more broad-based inflation, monetary policymakers across the world have spoken about so-called "second-round effects" from inflation into wage setting. Recent data for the euro area does not suggest, at least thus far, that higher inflation in 2021 is feeding into broad-based higher wage demands, although the upheaval in the labour market makes it more challenging than ever to extract timely and accurate insights from the data.
Monetary policy's primary effect is through the demand side of the economy. We, therefore, need to be conscious of the effects of tightening policy when the recovery from the pandemic in the euro area remains highly uncertain and incomplete. The wrong monetary policy action today could prove more costly than the risks stemming from the current spike in inflation. Over the medium term, it could slow economic growth unnecessarily, which could prevent inflation reaching our target in a sustainable manner.
While lower-income households suffer more from energy-driven inflation, they are also more vulnerable to a contraction in demand that would reduce employment. Constraining demand now to bring it back into line with what might be a transitory supply interruption would then depress incentives for supply to return. Having said that, we cannot afford to be complacent. We need to recognise that there are risks to the inflation outlook. If current trends in inflation persist, the case for monetary policy action will become stronger.
Turning to other policy levers, Government decisions on expenditure and tax revenue can have an important impact on economic growth, inflation and the broader economy and labour market. While action is needed to address infrastructure deficits in housing and to meet the challenges of climate change, any investment, given the current economic backdrop, needs to be managed carefully and accompanied, where necessary, by structural reforms to ensure that the demand it generates does not lead to excessive inflationary pressures. Put simply, the economy as a whole does not need, nor would it benefit from, expansionary fiscal policy in the coming years. This does not mean that targeted measures which do not add to overall demand in the economy and which offset the negative impact of current inflation on the most vulnerable are misplaced. More generally, since Ireland is a small, open economy in the euro area, fiscal policy has an enhanced role here as the main instrument of macroeconomic stabilisation. Dr. Cassidy and I are ready to take the committee's questions.
