Inflation could remain higher in Ireland

There was quite a hullabaloo about inflation during 1999/2000, when the annual headline rate climbed from 1.5 to 7 per cent. The underlying rate (i.e. excluding mortgages and changes to indirect taxes) doubled from 2.5 to 5 per cent.

The furore largely subsided last year as the economic slowdown took centre stage. Further, declining mortgage rates, falling oil prices and cuts in indirect taxes saw the annual rate of headline inflation fall from 7 per cent to below 4 per cent by November 2001.

The decline in the headline inflation rate masks the fact that there is continuing strong upward pressure on consumer prices. When excluding changes in mortgage rates and indirect taxes, it is found that the underlying level of inflation remained relatively high during 2001, at around 5 per cent.

This is all the more disappointing, as a sharp fall in oil prices should have triggered a decline in the underlying inflation rate. Indeed, all measures of inflation picked up sharply again in Dec-ember.

Furthermore, there was a marked intensification of price pressures in some sectors of the economy over the past year or so. Food price inflation has accelerated sharply to 6.5-7 per cent.

Domestically produced food products are the main offenders even though farm output prices have fallen since last summer, while the rise in factory output prices for food products slowed from 5 per cent to 1 per cent during 2001.

Another sector that showed a marked acceleration in inflation last year was alcoholic drinks.

Here the rate of inflation accelerated from under 4 per cent in January to almost 6 per cent by December, despite a 1 per cent cut in the VAT rate. Again, the rate of drink price inflation at the factory gate level has been much more modest, at just 2 per cent.

The most worrying pick-up in inflation, however, has been in the services sector.

In this sector the annual rate accelerated to 8.3 per cent in December from some 4 per cent in the first half of last year. High and rising inflation has been evident across a broad array of services.

The above three sectors account for more than half the consumer price index. They have a common feature in that they tend to operate in closed sectors of the economy, not exposed to foreign competition. By contrast, open sectors such as clothing and durable goods are showing negative or very low inflation rates.

Why has inflation surged so much in closed sectors of the economy in the past couple of years?

The simple answer is a growing imbalance between supply and demand. The economy was able to grow rapidly during the second half of the 1990s without generating inflation because of the considerable degree of spare capacity. Investment spending was rising rapidly, while the unemployment rate was relatively high.

Thus, wage inflation was generally moderate during this period. By 2000, however, the spare capacity in the economy was used up.

Full employment was reached. Consumer demand remained strong, even in 2001, when there was a marked slowing in output growth. The result has been a marked acceleration in wage inflation in the past two years.

Wage growth accelerated to some 10 per cent in the public service, financial services and general services sectors in the first half of 2001.

Meanwhile, manufacturing and construction were showing annual wage growth rates of 12.5 per cent and 13.5 per cent, respectively, by September 2001. It is little wonder, then, that consumer prices are rising rapidly.

Strong inflationary pressures would now appear to be deeply embedded in the economy. Saddled with very low interest rates and a weak exchange rate, there is little the authorities here can do.

A tighter budgetary policy would be appropriate but there is little appetite for this at the present time. In any event, the scope for fiscal policy to lower inflation significantly in a small open economy such as the Republic is very debatable.

Thus, unless the recent economic slowdown turns into a deep recession, inflation is likely to remain much higher in the Republic than elsewhere in Europe.

At present, the average harmonised measure of inflation stands at 2.1 per cent in the euro zone and 1 per cent in Britain, compared to 4.4 per cent in the Republic. Wage growth in the EU is running at low single-digit levels, or about one-third the level of the Republic. This is simply not sustainable.

In the short-term, the low level of the exchange rate is helping to offset some of the losses in competitiveness. Thus, economic growth is likely to recover in line with the US during the coming year and into 2003.

Inflation, however, looks set to remain high and this could eventually lead to a more sustained period of below-trend growth in the Irish economy.

Such a downturn would prove all the more severe if it is accompanied by a rebound of the euro, especially against sterling.

Oliver Mangan is chief bond economist with AIB Group Treasury