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Squeeze on real incomes will make it feel like a recession

Inflationary surge set to trigger biggest drop in living standards since 2008 financial crisis

In the face of war, accelerated inflation, rising interest rates and a likely recession in the euro zone and the United States, the Irish economy is expected to grow by almost 7 per cent this year, a performance that probably won’t be matched by any other country.

At the same time, the Economic and Social Research Institute (ESRI) is predicting the biggest drop in living standards since the brutal aftermath of the 2008 financial crisis as earnings from work fail to keep pace with soaring inflation.

The globalised, multinational-dominated sectors of the Irish economy are the envy of the world but they’ve made a nonsense of our economic metrics.

With inflation expected to average more than 7 per cent this year – it could be higher – and earnings expected to grow by just 3 per cent, real household disposable incomes will contract.

By definition, a recession requires back-to-back quarters of negative GDP (gross domestic product) growth, but GDP, in the Irish context, is warped by the activity of multinationals. Not meeting the criteria for a recession is a technical point, the squeeze on real incomes here will almost certainly make it feel like a recession. Make no mistake, the political and economic temperature in this country is about to change.

The headline forecasts also contain significant downside risk, not least because most agencies and central banks have been caught out by the level of price growth and because both the US and euro area are now threatened by recession.

The ESRI believes inflation in the Irish economy will peak at 8-9 per cent in the coming months – it is currently running at 7.8 per cent – before falling back to 4 per cent next year. That’s a big call. The European Central Bank has been playing catch up on inflation, constantly low-balling the actual out-turn, and Europe’s energy crisis, heavily predicated as it is on Russia’s war in Ukraine, has a dynamic that few can forecast for sure.

The Bank of England believes inflation in the UK will rise to more than 11 per cent but there is the Brexit effect to consider in the UK’s current woes (red tape has driven up the cost of imports, adding to inflation).

Either way, the erosion in real incomes could be deeper. In many ways, we’re in the quiet before the storm as households run down savings to pay for higher living costs and before the critical winter heating requirement emerges.

And then there is the expected increase in interest rates. The ECB has flagged a sequence of rate hikes from next month.

The rise in mortgage repayments for the 470,000 people in Ireland on tracker or variable contracts will be the fourth big ticket item on household bills to rise, after energy, food and transport. The initial rate increase, expected to be 0.25 per cent, will add roughly €50 to the monthly repayments of a typical €300,000 mortgage. Not particularly severe.

However, if the ECB was – over a period – to raise rates by 2 per cent, as some of the more hawkish members of the ECB’s governing council are advocating – the financial fallout could be significant. A move of that magnitude would add €335 to the monthly repayments on a €300,000 mortgage and €670 for a €600,000 mortgage.

And as last week’s Eurostat survey on prices, which pinpointed Ireland and Denmark as the most expensive countries in the European Union, illustrates we’re starting this inflation narrative from a bad place.

According to the ESRI, the positive growth outlook – in GDP terms – owes much to multinational exports. Exports drove us out of recession back in 2010 and have remained buoyant throughout the pandemic. In the first quarter of 2022, net exports – the value of exports minus the value of imports – amounted to €53.3 billion.

The big risk is that inflation becomes embedded in the economy through second-round or spillover effects.

In its report, the ESRI highlights that the increase in prices excluding energy products was 4.7 per cent in May, compared with 7.8 per cent for overall inflation.

“The rising level of non-energy CPI [consumer price index] also highlights the risk of domestic factors beginning to feature in the inflationary process in Ireland,” it said.

And then there is the fear that inflation could create a dreaded wage-price spiral. This forms the backdrop to the stalled public-sector pay talks. With wages rising at a rate of 3 per cent, the risk of a spiral seems remote. However, the ESRI warns that when unemployment falls to 4 per cent and below, the acceleration in wage levels could be more pronounced, as companies chase a shrinking pool of labour. Unemployment is currently at 4.7 per cent but predicted to fall to 4 per cent next year on the back of chronic labour shortages across the economy.

“The Irish economy will be operating at or close to full employment over the period ahead. This is likely to lead to upward pressure on wages as demand outstrips supply in the labour market,” the ESRI said.

With the lifting of Covid restrictions, 2022 was meant to be the bounce-back year. It is proving anything but.