Budget shifts focus of attention to domestic influences on economy

INVESTOR: The forecasts for economic activity next year are unlikely to be altered materially due to budgetary changes

INVESTOR: The forecasts for economic activity next year are unlikely to be altered materially due to budgetary changes

The highly open nature of the Irish economy and financial markets means that international developments have a large and immediate impact on the Irish economy and financial markets. However, the unveiling of the Budget has naturally shifted the current focus of attention onto domestic influences.

In addition, the Budget occurred very close to the announcement by the European Central Bank (ECB) of a cut of half a percentage point in short-term interest rates. These changes combined add up to significant changes in both monetary and fiscal policies that will have far-reaching implications for the progress of the economy in 2003 and beyond.

We should turn first to the Budget which was the first in several years that presented the Government with very difficult choices.

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From a macroeconomic perspective the Budget will probably have a neutral impact on economic activity next year. The increased tax burden will certainly act to dampen economic activity provided that the Exchequer stays within spending limits.

However, some slippage on spending, particularly in relation to public sector pay, seems inevitable.

The net result is that forecasts for economic activity for 2003 are unlikely to be materially altered due to budgetary changes.

From the business perspective, there were some changes at the micro level that do have a direct impact on company profitability. The most obvious is the extra €300 million to be raised from financial institutions over the next three years.

Changes in the timing of capital allowances will also have a significant impact on sectors that require high capital investment as these capital tax allowances will now be spread over a much longer period of time.

On the positive side, the planned reduction in the rate of corporation tax to 12.5 per cent is being implemented. This means that the rate of corporation tax will be one of the lowest in the world.

Therefore, while some changes to the tax code will increase the burden of tax on business, the low overall rate of corporation tax ensures that Ireland will maintain its position as a very fiscally attractive business location.

Turning to monetary policy, the reduction by 50 basis points (to 2.75 per cent) in short-term interest rates by the ECB came as no real surprise to financial markets.

This reduction comes at a good time as it will provide some stimulus to the economy.

This contrasts with previous reductions in euro interest rates that occurred while the Irish economy was still booming. With Irish inflation forecast to average 4.8 per cent in 2003, short-term real interest rates are negative and will cushion any further downturn in overall business activity.

The accompanying table highlights just how low global interest rates are.

Japanese short-term rates have now been zero for well over a year and seem set to remain at zero for the foreseeable future.

In the US the Fed Funds rate is now very low at 1.25 per cent and is three quarters of a percentage point lower than one year ago.

Sterling interest rates have been maintained at what now seems like a relatively high 4 per cent as the Bank of England struggles to keep a lid on the booming Britsh housing market.

European rates now sit in the middle of British and US interest rates.

From Ireland's perspective, the recent cut in euro rates widens the gap with sterling rates and probably lessens the prospects of Britain joining the European monetary union in the near future.

In contrast to short-term interest rates, British, US and European bond yield differentials are much narrower.

For example, German 10-year bond yields of 4.4 per cent are marginally lower than the equivalent British yield of 4.6 per cent. This suggests that the financial markets are viewing the long-term inflation prospects for Britain and the euro zone as quite similar.

This may seem to be somewhat at odds with the more stringent approach taken by the ECB to controlling inflation.

However, there are signs that the ECB may be preparing the ground for a shift in policy. It is planning to re-assess its approach to monetary policy early next year.

There are signs that the bank may soften its 0-2 per cent inflation target which is being criticised as too low at a time when deflation poses a greater threat than inflation.

It is also expected that the bank may focus more on "real-economy" indicators - making its interest rate policy more receptive to changes in the real economy.

From the Irish perspective, this would seem to copperfasten low interest rates for as long as the European economy grows below par.

Taken in conjunction with a reasonably healthy budget position, this implies that fiscal and monetary policy will be supportive of economic growth over the next 12-18 months.