ESRI warns of overheating as it upgrades economic growth forecast

The Government risks overheating the economy if it fails to keep a tight rein on spending in the post-Covid period, the Economic and Social Research Institute (ESRI) has warned.

Ahead of next week’s budget, the think tank said that increased Government expenditure in areas such as housing, climate change and healthcare was coinciding with a period of rapid growth in the domestic economy and this could add to existing capacity pressures.

In its latest quarterly assessment, the ESRI said the Irish economy would register robust growth of 12.6 per cent this year and 7.1 per cent next year on the back of a resurgence in consumer spending and a further acceleration in exports.

The stronger-than-expected performance will ease pressure on the public finances, it said, while leading to a significant reduction in unemployment. Unemployment is expected to fall to 9 per cent this year, down from a pandemic high of 31 per cent in April 2020.

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However, the rapid bounceback, combined with increased public investment in infrastructure, posed a significant risk of overheating, it said.

Overheating occurs when demand exceeds the productive capacity of the economy, bidding up prices and wages and eroding competitiveness.

“The need for greater investment is coming when the economy will be experiencing strong rates of growth,” the ESRI said. “It is important, therefore, that restraint be demonstrated in terms of current expenditure in order to reduce the possibility of overheating in the domestic economy.”

Capacity constraints

The Central Bank warned on Wednesday that a significant public spend on housing could run up against capacity constraints, primarily related to labour shortages, which may fuel further inflationary pressure in the sector.

In its report, the ESRI noted that the required increase in new housing output was also occurring at a time when there was increased focus on housing retrofit to reduce climate emissions.

“This is likely to add to the existing capacity pressures in the sector,” it said.

ESRI economist Kieran McQuinn said increased public spending on vital infrastructure would also “necessitate” extra revenue to be raised either through increased taxes or additional borrowing.

However, relying “purely” on increasing taxes to meet the investment challenges would have implications for the competitiveness of the economy, he said.

Instead, he said, the ESRI recommended running a small but sustainable deficit over the medium term.

The Government’s recently revised budgetary strategy envisages a series of bigger annual deficits over the medium term on the back of an additional €19 billion in borrowing. It replaced an objective of gradually moving to a balanced budget position by 2025.

Inflationary pressures

In its report, the ESRI noted that inflationary pressures in the Irish economy were beginning to pick up.

“While some of these effects are transitory (coming from so-called base effects), global factors such as higher energy prices are also playing a role,” it said.

“Further inflationary risks, in particular in domestically non-traded goods and services, could materialise if the domestic economy recovers particularly rapidly,” it said.

The institute said the stronger-than-expected growth performance would ease “somewhat” the pressure on the public finances. It predicted the Government would generate a smaller-than-expected budget deficit of just under €15 billion this year.

The significant reduction in unemployment would also help to restore the public finances to a more sustainable long-term path as the economy slowly emerged from the pandemic, it said.