How to stop the economic boom being consumed by rising prices

After years of low inflation, rising prices are now emerging as a key economic problem for the Government. Soaring consumer prices are already putting pressure on the new national wage agreement and, together with rising house prices, the worry is that a wage spiral could threaten competitiveness and the economic boom.

In a small open economy such as Ireland's most prices are determined outside the State. Rising oil prices and a weak currency have put pressure on the consumer price index. However, rising excise duties, particularly large price increases on cigarettes, have added to the inflationary equation and are within the control of the Government.

The social partners are worried that the recently agreed national programme may stand or fall based on the level of consumer prices inflation over the coming months.

The most recent figures showed prices rising at 4.6 per cent a year and at 5 per cent when the EU's measurement is used. That compares with a euro zone average of 2.1 per cent. One of the main problems for the Government is that the 5.5 per cent pay increases agreed under the Partnership for Prosperity and Fairness (PPF) do not look at all generous when compared with these inflation figures.

The Minister for Finance, Mr McCreevy, has been bullish in insisting that inflation will rise to 5 per cent before falling back to the 3 per cent average forecast by his Department for this year, although that is likely to be revised upwards very soon.

However, according to Mr Jim O'Leary, chief economist at Davy Stockbrokers, this is implausible. Inflation would have to average 2.6 per cent for the next nine months for this to happen. His estimate is for inflation of 4.3 per cent on average, unless measures are adopted to relieve price pressures. The social partners are anxious to reduce inflation, although it is understood that the agreement was based on average inflation this year of 4 per cent, higher than the Department of Finance's own estimate. Without some decrease, the PPF may be in jeopardy and any renegotiation of the agreement could feed into a wage price spiral.

Proposals to rescue inflation were thus at the top of the agenda at a meeting of the social partners yesterday. Union leaders called for lower duties on petrol and diesel fuel. They argue that rising oil prices have accounted for almost a third of the cost of living increase in the past year and a cut in excise duties would offset some of that.

However, the employers' organisation IBEC and other commentators remain cautious, pointing to the environmental cost of a cut in energy taxes, among other factors. Mr O'Leary points out that crude oil prices have already fallen substantially and this reduction should begin to feed through to the inflation figures in a month or two. In addition, it is difficult to argue that the State could be serious about meeting its environmental commitments agreed at the Kyoto summit if it is encouraging greater consumption of energy. Traffic congestion is yet another reason why energy taxes may not be the route to go, they argue. However, these methods would merely tackle the symptoms and not the cause of the problem.

There are a number of underlying causes for rising prices. Inflation bottomed out at 1.2 per cent in July last year and is now at 4.6 per cent. The 3.2-point difference is made up of mortgages which account for 0.7 of a point, with the same amount on tobacco. Energy prices accounted for 1.2 percentage points with traded goods accounting for 0.5 of a point and non-traded services for 0.4 percentage point.

Most of these are factors that the Government cannot do anything about. Mortgages are certainly beyond its influence, energy prices are set at the world level, although excise duties - which are within its command - do make a difference.

The inflation in traded goods such as clothing and footwear is probably mostly due to the weakness of the euro, while rising prices in non-traded services - restaurants, for instance - is the result of general inflationary pressures and wage rises within the economy. Tobacco prices are totally the responsibility of the Government and the 50p rise at the last Budget was curious in that it was not offset by a cut in indirect taxation on something else. Without this, inflation would now be running at some 3.8 per cent.

Nevertheless, a cut in indirect taxes would make a difference. According to Mr Colin Hunt, chief economist at Goodbody Stockbrokers, a 2 percentage point cut in the top rate of VAT would take about 1.3 percentage points off the inflation rate. If an alternative excise duty measure was chosen, the Government would have to give up about £200 million in indirect taxes to take one full percentage point off the consumer price index, according to Mr O'Leary.

Apart from that, the Government will have to hope that the euro begins to recover later this year. This has been the forecast of many analysts almost since the currency's inception 16 months ago. And in that time it has fallen by more than 20 per cent.

Some international bankers are predicting that the currency could fall to around 88 cents and stay there for some time. If that were to happen, this could fuel inflation further as a fall in the currency threatens to push up the prices of all goods imported from outside the euro zone. It is difficult to know to what extent this would feed into the inflation figures.

Mr John FitzGerald, research professor at the ESRI, has pointed out that more firms, even those in the UK, are invoicing in euros. As a result they are sacrificing margin for market share. If that continues, the impact of the weakening euro will be somewhat limited.

However, if more retailers pass on the increasing cost of goods, it could move through quickly. Goodbody's Mr Hunt has estimated that if the euro remains at the current level it could add about one percentage point to forecasts. If that proves correct, Mr McCreevy is likely to have little choice but to cut VAT or excise duties.