Our initial forecast for inflation for 1997 was 2 per cent, at the low end of expectations. By mid year this forecast was revised down to 1.7 per cent. Irish inflation data for July, published yesterday, led us to believe 1.5 per cent will be the outcome. Yet the economy in the last few years has averaged 7 per cent growth rates. Credit has been growing at a double digit pace since late 1994 and house prices have moved up sharply. As a result, worries of overheating have dominated much of the media and analyst coverage.

There are, however, grounds for believing that such worries are misplaced, provided appropriate policies are pursued. Recent reviews by the Central Bank have confirmed that inflation in Ireland is dominated by changes in the trade weighted exchange rate and by inflation in our main trading partners. In 1996, the trade weighted exchange rate rose by 2 per cent and inflation in our main trading partners was less than 2.5 per cent. Against such a background, it is not surprising that Irish inflation remains well behaved.

The decline of the Irish pound against sterling has been expected by many to be inflationary, however there is no evidence to date that it has, apart from the books and newspaper sector. The rise in sterling, a more correct description, has put downward pressure on the sterling prices of British suppliers and this reduces or eliminates the impact on Irish inflation. The opportunity to source substitute product in say Germany, against whose currency the Irish pound has risen, is the key to this process.

The prospects for inflation next year depend on what exchange rate level Ireland chooses to enter EMU. If the ERM central rate is chosen and sterling remains broadly unchanged, the Irish trade weighted index will fall by more than 8 per cent by the end of 1998 and inflation should accelerate accordingly.

There would be no economic force at work to force down the sterling or deutschmark price of imports to Ireland in this case and the price pass through could be rapid. A critical consequence would be the pressures this could bring for revisions to the wage agreement.

The exchange rate is thus critical to the inflation process in Ireland and growth which is "too rapid" will adversely affect primarily the balance of payments and not inflation directly. The fact that the current account remains in surplus and the external reserves are rising in recent years indicates this is not the case.

As far as the rapid pace of growth is concerned, the prospects appear good. Mr Greenspan, chairman of the US Central Bank, recently testified that capital investment in the US in computer and telecommunications equipment has grown in volume terms at 25 per cent per annum since 1993. Ireland is now an important centre for such technology-based companies. Electronics and chemical production in Ireland has grown at over 13 per cent per annum for 10 years and now represents more than 40 per cent of manufacturing output.

These companies export more than 80 per cent of their output. Ireland's peripheral location is not a barrier to investment by new technology companies because material inputs are low and easily transportable and the outputs are high value/low weight. The investment decision for such companies depends crucially on the quality and availability of labour and the overall infrastructural and business environment.

This contrasts with companies in heavy manufacturing, which dominated investment for much of this century, where closeness to raw materials and markets were much more important in the location decision.

Ireland is attracting investment in new technology partly because of the growth in the population of working age, a key determinant of growth potential for the economy. In Europe and the US the growth in population of working age is running at about 0.5 per cent per annum. In Ireland the growth rate is 2 per cent to 3 per cent per annum. This pace is set to continue to 2001 and at a slightly slower pace to 2006.

The long run pace of growth of output per head in Ireland, the other key determinant of growth potential, is running at 3.5 per cent to4 percent per annum. Since new entrants to the labour force have higher educational levels and presumably higher levels of output per head than those retiring, the prospects for growth in overall productivity are good.

Thus, the Irish economy has the potential to grow at about 6 per cent or more per annum, i.e. growth of labour force 2 per cent to 3 per cent plus productivity close to 4 per cent. At such a pace, only the growth in the labour force would be absorbed and unemployment would not be declining. Substantial reduction of unemployment requires growth rates above 6 per cent such as have been experienced in the last few years.

This analysis takes no account of the fact that demand for labour in the small Irish economy can be met from a very large global labour market. This market is made up of the large numbers of Irish emigrants, many with valuable experience, who could return as well as potential immigrants from Britain and elsewhere in Europe. This helps explain why rapid growth has not resulted in a significant acceleration in wages. Employment is growing by about 50,000 per annum, but average earnings per hour in the industrial sector are rising at less than 3 per cent and not much more than 4 per cent for skilled construction sector workers.

Asset price inflation has accompanied rapid growth. Equity prices have risen as expected company profitability has increased. Commercial and residential property have been driven by the same forces. These are part of the normal process of the functioning of the price mechanism in the economy and are not per se undesirable. Rising house prices would constitute a problem if wage increases were gained in response to the rise in housing costs, as was the case in Britain in the late 1980s. There is little evidence that this is taking place here. The steam appears to have gone from the starter home market because wages have failed to rise with house prices.

Credit growth has provided an important focus for overheating concerns. However, the structural changes in the economy outlined above require rapid credit growth. If the labour force is growing at more than 30,000 per annum, the rate of household formation might be expected to be similar.

Mortgage credit growth, which is running at 14 per cent per annum, is consistent with such numbers and, from what has been said above can be expected to continue at this pace for the next few years. In summary, we should begin to believe more in the opportunities for Ireland in the global economy. Overheating is not evident, nor is it clear at what pace of growth it could emerge. Investment in education and infrastructure are central to success in the global economy. Clarity about exchange rate policy is important for inflation expectations and investment decisions.

Eunan King is Senior Economist with NCB Stockbrokers.