Central Bank governor warns cost-of-living supports must be temporary

The governor of the Central Bank has warned the Government that budgetary measures to cushion the impact of inflation need to be temporary and targeted to limit the risk of fuelling further price growth.

In a pre-budget letter to the Minister for Finance, Gabriel Makhlouf also highlighted the significant budgetary risk posed by corporation tax receipts, suggesting the public finances were now “highly exposed to business decisions of a small number of firms”.

He said Budget 2023 was taking place against a highly uncertain and challenging economic backdrop. “The economy began 2022 with strong momentum as the impact of the pandemic subsided, but now faces numerous headwinds, including energy price shocks and supply chain pressures that have resulted in high inflation,” he said.

High inflation and heightened uncertainty were reducing consumer and business confidence, with signs that this was having a negative effect on spending by households and firms, Mr Makhlouf said. The Government’s budget must focus on building resilience for the medium term as well as addressing shorter-term challenges.

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“As the European Central Bank (ECB) governing council indicated last week fiscal support measures to cushion the impact of higher energy prices should be temporary and targeted at the most vulnerable households and firms to limit the risk of fuelling inflationary pressures, to enhance the efficiency of public spending and to preserve debt sustainability,” he said.

The Government is planning a major cost-of-living package in the budget with up to €2 billion in temporary, once-off measures to offset the impact of inflation. However, economists fear that untargeted measures to shield households, such as energy credits or further cuts in excise duty, could end up fuelling further domestic inflation, which remains at a near four-decade high of 8.7 per cent.

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Mr Makhlouf said the Government’s fiscal policy stance in Budget 2023 should be framed around four key priorities: ensuring those most vulnerable to the inflationary shock are supported through temporary, targeted supports; increasing Government investment and supporting public services; building resilience in the public finances; and building resilience in the economy by sustainably addressing the structural challenges around infrastructure, climate change and population ageing.

While noting the improvement in the public finances that has occurred over the past 18 months and the likelihood of a small budget surplus this year, he warned that corporation tax receipts had played a key role in supporting overall revenue growth and represented “a significant budgetary risk”.

“Having increased by more than 40 per cent between 2019 and 2021, corporation tax receipts have continued to grow rapidly and surpass expectations in the first half of this year,” he said.

Central Bank research suggests that up to €8 billion – more than half of last year’s receipts – cannot be explained by developments in the underlying economy and therefore could be potentially unsustainable.

“There are also large concentration risks given the very high proportion of the tax paid by a relatively small number of companies in a limited number of sectors such as ICT and pharmaceuticals,” Mr Makhlouf said, noting €1 in every €8 was now stemming from just 10 large firms. “This leaves the public finances highly exposed to business decisions of a small number of firms, or negative firm or sector-specific shocks.”

On last week’s decision by the ECB to increase interest rates by an unprecedented 0.75 per cent, the governor said the bank was acutely aware of the impact that increasing prices has on families and businesses “and returning inflation to our medium-term target of 2 per cent remains our overriding priority”.

“That is why we decided to continue to take steps to tackle inflation by increasing our interest rates last week,” he said.

The aim, he said, was to ensure that the benefits of price stability for households, businesses and the wider economy were realised.

“However, it is also increasingly clear that we are in a different inflation/interest rate environment than has been the case in the years leading up to the pandemic,” Mr Makhlouf said, noting the governing council expects that further normalisation of interest rates will be appropriate, with the future policy rate path continuing to be data-dependent and focused on delivering a 2 per cent inflation target over the medium term.