Ireland's economy is now entering a crucial phase which an expansionary Budget or large wage rises could undermine, the Central Bank warned yesterday.

In its quarterly bulletin, the Bank noted that there was obvious international pressure from high oil prices and the weak euro but also cautioned that the impact of budgetary policy could play an important role.

Inflation, forecast to be an average of 4 per cent next year on the basis of optimistic assumptions, is set to remain a problem and could be even higher depending on the effects of the weak euro and rising oil prices. In accordance with normal central bank procedures, the Bank based its assumptions on unchanged interest and exchange rates and, more crucially, on a neutral Budget which its spokesman admitted was what it would like to see rather than what it expected. In a separate article within the bulletin, two of the Bank's economists warned that last year's Budget was expansionary. They did not quantify how much its provisions added to the Consumer Price Index but the Bank's head of economic affairs, Mr Tom O'Connell, insisted that another giveaway Budget would add to inflation.

Wage rises, particularly if firms pass on the higher costs to consumers, are also a danger, according to the Central Bank. It is predicting wage growth of 7.5 per cent this year and 7.75 per cent next year, based on the general overrun on previous national agreements. Mr O'Connell admitted that the pressure on the current agreement, the Programme for Prosperity and Fairness, was unprecedented and he conceded that all wage rises were not necessarily wrong.

He noted that the OECD has stated that higher inflation could allow the economy gradually to lose competitiveness and thus could be a good thing. But the danger, he said, was overruns, giving rise to expectations which were building up across the economy as a result of high house prices, commercial property prices and wage rises. If these became ingrained it could be difficult to get inflation out of the system.

"In other states it has been found that recession is the only way to get inflation out of the system. That does not mean we are going to have negative growth here but it does mean that indigenous firms in particular could rapidly lose competitiveness," he said.

The Bank also warned that rising inflation could see the competitiveness of the economy being severely impaired and it predicted that the indigenous sector would suffer most.

The attractiveness of Ireland as a location for foreign direct investment would also be diminished. However, for now, continuing huge productivity gains among multinational firms in particular meant that competitiveness was still growing.

Mr O'Connell noted that inflation, if it did not become ingrained, could mean that prices were simply catching up with the rest of Europe. The completion of that process would result in price rises falling automatically. He added that inflation at about 3 per cent - or just 1 percentage point ahead of the euro zone target - would be sustainable given the higher growth rates here. The Bank is estimating that Gross Domestic Product will rise by 10.2 per cent this year before slowing to 8.8 per cent in 2001.

The Bank believes that if this sort of price stability can be achieved, the medium-term outlook for the economy is good. "A stronger euro would also make it easier to ensure that price stability is maintained and this is in Europe's longer-term interest."

But in the meantime, the Bank also warned that core inflation - which excludes volatile fresh food and energy prices - is likely to go on rising this year and next. The core rate has been rising almost continuously since the beginning of 1998 from a rate of about 2 per cent to around 4.5 per cent, mainly because of an increase in inflation in the key services sector.