The complex impact of sterling on the Irish economy

Cantillon: Central Bank analyses the impact of sterling depreciation

Depreciation in sterling reduces Irish import prices, which feeds through to lower consumer prices here. Photograph:EPA

Depreciation in sterling reduces Irish import prices, which feeds through to lower consumer prices here. Photograph:EPA

 

In a separate article in its latest quarterly bulletin, the Central Bank examines the potential impact here of major depreciation in sterling.

To isolate the effect of the shock, it compared the responses of key macroeconomic aggregates to a 10 per cent sterling depreciation, which is roughly what has happened since the Brexit vote, to a baseline without the shock.

It found the two main channels through which the shock would affect the Irish economy are the competitiveness effect and the impact on foreign demand for Irish exports.The third mechanism identified was the pass-through effect on consumer prices.

First the falling value of sterling improves the competitive position of UK exporters and consequently has a negative impact on the traded sector here, which becomes less price competitive.

However, this in turn gives rise to two offsetting effects. The increase in the UK gross domestic product (GDP) will stimulate demand for Irish exports, but because it becomes more expensive for the UK to import from abroad, the demand for Irish exports would be lower.

Another effect is that the depreciation in sterling reduces Irish import prices, which feeds through to lower consumer prices here.

In actual numbers, the Central Bank’s analysis found the level of output in the traded sector here was about 0.4 per cent lower after three or four years of the depreciation before falling to 0.2 per cent in the long run. This decline is driven by a deterioration in Ireland’s relative competitive position. The decline leads to small fall in employment and wages, which in turn reduces household consumption. With lower domestic demand there would also be a hit for the non-traded sector.

Overall the aggregate impact on the level of GDP here is just under -0.2 in the long run. The analysis shows that in terms of inflation, the fall in import prices would result in the level of consumer prices being around 0.3 per cent lower in the short run. In conclusion, the Central Bank notes this fall in prices helps to moderate the decline in real incomes and consumption as a result of the shock.