Inflation disappointing but not disastrous

Ten years ago this month the Irish inflation rate stood at 4.2 per cent, having reached 4.7 per cent in the preceding November, and proceeded to fall throughout the year, to finish at 2.6 per cent. Inflation never again threatened 4 per cent in the 1990s, averaging just 2.25 per cent over the decade. It is not surprising then, that the latest inflation reading, showing a rise to 4 per cent in January, should provoke comment, not least from the "crash school", which for years has looked askance at the Republic's combination of heady growth and low inflation while muttering the words "overheating", "bubble" and "hard landing".

Without doubt, the Consumer Price Index (CPI) reading was disappointing, but it is not the disaster some would have us believe. The current inflation rate begs two questions: does it matter and, if so, can we, or more precisely the Government, do anything about it?

The conventional policy response to a rise in inflation is for the Central Bank to raise interest rates but in the Republic's case, that option is not open, as the European Central Bank (ECB) now controls monetary policy. Yet the Government can still affect the economy via spending and taxation policies, so some believe that taxes should not have been cut in the Budget.

However, a closer look at the data confirms that conditions in the Irish economy have only a small impact on price developments: the inflation rate would not be dramatically different if the economy were growing at 2 per cent, 5 per cent or even 10 per cent, and tax cuts will have little impact on prices. That is because imports in Ireland amount to over 75 per cent of GDP, and inflation is largely determined by world price trends.

Take energy costs for example: the price of oil rose from €9.50 per barrel in early 1999 to €24 in December, and has climbed further in the past few months to stand at €27. This has pushed fuel and transport costs up across the globe and the Republic is no exception: energy costs in January were 12 per cent higher than a year ago, which directly added some 0.6 percentage points to the January CPI i.e. excluding energy, inflation would be 3.4 per cent. High street prices are also largely determined by world prices for manufactured goods (which are falling and will decline further as the Internet becomes all pervasive) and by the degree of local competition, which has greatly increased in recent years. So it is not surprising that the prices of clothing, footwear and durable goods have been stable or falling in recent years.

Indeed, the January sales saw steeper discounts than a year earlier, taking clothing and footwear prices an astonishing 30 per cent below their levels of late 1996, with durable goods over 3 per cent down. The other main negative in the CPI was cigarettes, which are 17 per cent higher than a year ago, adding 0.9 points to the inflation rate. Again, however, this has nothing to do with a spending binge by Irish consumers: the Minister for Finance is responsible for virtually all the impact by imposing the swingeing rise in excise duties in the Budget. There may be a strong argument that the price of cigarettes does not reflect the social and health-care costs of smoking, but the timing of the increase is puzzling, as without it inflation would be 3.1 per cent.

So for Irish goods that are traded internationally it is world prices rather than domestic spending which matters. This doesn't apply to services, which are generally not traded: we cannot import child creches, cinemas or restaurants. That means that strong domestic spending can have an impact which is clearly visible in the January data: services inflation was 5.8 per cent, unchanged from December. Yet this component accounts for only 16.5 per cent of the index, so the traded-goods sector dominates, and our inflation rate will depend more on what happens to the price of oil, the world price of manufactured goods and the value of the euro than on domestic spending. On that basis there is little the Government can do, bar deregulation and the removal of barriers to competition, which is the mechanism to reduce services inflation.

Finally, does it matter that inflation is 4 per cent and that it will probably move marginally higher for a few months before declining, assuming oil prices do not rise further. For anyone on a fixed income it certainly does, but for the broader economy wage trends are much more important, as that determines the Republic's competitiveness within the euro zone.

So if wages rise by 56 per cent over the next few years, as projected in this latest partnership agreement, competitiveness will not suffer and will continue to rise in manufacturing. So the only danger is that workers reject that inflation will fall back and average 2.5 per cent over the next three years (the assumption underlying the Programme for Prosperity and Fairness).

If the pay deal holds in broad terms, the inflation seen in early 2000 will come to be viewed as a blip in an otherwise benign price environment.

Dr Dan McLaughlin is chief economist with ABN-Amro Group