Rising inflation muddies the water for McCreevy in shaping Budget strategy

Inflation is now close to its peak, most economists agree, but that peak has come so late in the year that high inflation will now spill over into 2001 unless the Minister for Finance takes decisive action next month in the Budget.

Inflation is likely to be 5.5 per cent at the end of the year, according to most economists, including Mr John Beggs, of AIB Group Treasury and Dr Dan McLaughlin of ABN Amro. This suggests an inflation rate of at least 4.5 per cent for 2001 in the absence of any counter-measures in the Budget.

Continued high inflation next year would undermine the already fragile Programme for Prosperity and Fairness even further by fuelling wage demands. The impact on business confidence would also be considerable.

The most obvious Budget option for Mr McCreevy is to cut some indirect taxes that directly affect the consumer price index. This would give him a lower base level going into 2001. The leading candidates are fuel and excise duties. An across-the-board cut in VAT is also a possibility.

With the latest figures, Mr McCreevy will also be under additional pressure to curb his plans to cut income tax, as such measures can be inflationary. The Taoiseach has already signalled that he would like to see tax cuts confined to low earners, where the inflationary impact would be minimised. A draconian or restrictive Budget is not the solution, according to Mr Beggs. Cuts in indirect tax should be made in tandem with cuts in income tax as the latter will help defuse demands for pay rises next year, he argues. Not all economists support the idea of cutting indirect taxes. Mr Aziz McMahon, treasury economist with Ulster Bank, warns that they may in themselves be inflationary. There is also the problem of ensuring that retailers pass on VAT cuts to consumers. The cuts are not needed as inflation may already have peaked, he believes.

The encouraging news for Mr McCreevy in yesterday's figures is that inflation does seem to be close to a peak, although it could yet top 7 per cent next month. The main external drivers of inflation, oil prices, interest rates and the weak euro, are on the wane.

No further interest rate rises are expected from the European Central Bank this side of the new year and the more optimistic forecasters say there could be just one more to come in the current cycle. "The evidence is that European and US growth has peaked," according to Dr McLaughlin. After its recent rallies the euro also appears to have turned the corner and is unlikely to lose any further ground before the year end, according to Mr McMahon while oil prices seem to have settled down.

Increased housing costs as a result of higher mortgage rates accounted for 0.3 of a percentage point of last month's 0.6 of a percentage point increase. Increased fuel costs accounted for two-thirds of the remainder, according to Dr McLaughlin. Fuel oil prices have risen by 61 per cent over the last 12 months, while mortgage interest costs are ahead 48.3 per cent.

There are also signs that the domestic drivers of inflation are falling off. The price of alcoholic drink has shown no increase, due primarily to the Government's price freeze.

The rate of increase in services inflation has fallen from a peak of 7 per cent to 4.9 per cent.

The only blot on the landscape is food price inflation, which remains high at 4.8 per cent compared to 2.4 per cent in April, according to Dr McLaughlin. Food accounts for around a quarter of the CPI and the Government's recent decision to keep the Grocery Order in place should underpin current prices. Food price inflation in the UK is 0.8 per cent by comparison and 2.1 per cent across Europe as a whole. More than 60 per cent of processed food sold in Ireland comes from Britain and sterling's strength is seen as a major factor in food price inflation, but does not account for all of the increase. Much of the clothing and footwear sold in Ireland also originates in Britain but the price of these goods rose by only 0.7 per cent last month and has fallen by 4.7 per cent on an annual basis.