The past year has seen a steady and sustained fall in Irish inflation, which in November stood at 2.2 per cent, down from 4.8 per cent 12 months earlier, and is now at levels last recorded in 1999.
Inflation has also fallen on the EU harmonised measure (HICP) and stands at 3.3 per cent, albeit still well above the euro zone average of 2.2 per cent.
Most commentators expect this more benign price trend to continue into 2004. The Department of Finance, for example, based its Budget projections on an average inflation rate of 2.5 per cent.
This forecast may prove pessimistic and the differential between Irish and euro area inflation may narrow in the short term but it is unrealistic to expect Irish inflation to move to the euro zone average over the next few years, nor is this necessary to protect Irish competitiveness.
Similarly, there are very good reasons why the Irish price level is higher than our euro zone peers and why this is not a cause for undue concern.
The persistence of inflation differentials between countries, even in a monetary zone such as the euro area, has prompted a host of academic studies, and the European Central Bank (ECB) recently published a summary of some of the findings.
From an Irish perspective, one of the most interesting and relevant conclusions relates to the impact of economic growth and, more specifically, productivity growth on inflation. The Republic's superior growth performance in an EU context can be partly explained by the influence of productivity growth, which has been consistently above the European norm.
At a simple level, this can be put down to two factors - the Republic has relatively more people working in manufacturing, where productivity tends to be higher than in services, and also has a relatively high percentage of workers in "new" manufacturing industries, which again have higher productivity growth than the more traditional industries such as cars or steel.
Not surprisingly then, Irish wage inflation has outstripped our European neighbours in recent years and it can be justified by the State's superior productivity growth.
Higher wages in manufacturing can be offset by the higher productivity, with no implication for price inflation. However, when this wage inflation transfers to services, the outcome is less benign because the service sector generally has much lower productivity growth than manufacturing - a 10 per cent pay rise in manufacturing might result in unchanged or even lower unit wage costs, but the same pay rise in services would probably raise unit costs by 10 per cent.
The end result is price inflation driven by the service sector and, on that basis, one would expect the Republic to have higher inflation than the EU norm precisely because of its unusually high productivity growth in manufacturing.
The ECB report quoted a number of studies that attempted to quantify the influence of productivity growth on inflation differentials and the average figure for the Republic was 1.3 per cent - i.e. Irish inflation will average 3.3 per cent against a euro zone norm of 2 per cent by virtue of this productivity effect.
But how does this square with actual price trends?
Interestingly, the average annual inflation differential between the Republic and the euro zone between 1995 and 2002 was 1.2 per cent - remarkably close to the theoretical figure. The fact that Irish inflation outpaced the EU average is understandable and is not a cause for concern, at least in terms of competitiveness - remember that services are generally not traded so competitiveness is largely a manufacturing issue.
By the same token, the State's superior productivity justifies high wages and a corresponding high price level - Irish prices should be higher than prices in Spain and Portugal, or even France and Germany, as the Republic's income per head is higher than all in the euro area with the exception of Luxembourg.
The Irish inflation differential has been higher than the norm in 2002 and 2003, it has to be said, but the differential could well narrow to 0.5 per cent or so in 2004. This partly reflects the limited nature of the indirect tax rises in the recent Budget, but the euro's external value plays a key part. The Republic imports far more from outside the euro zone than its European partners, relative to GDP, so the euro's value against sterling and the dollar has a much bigger influence on Irish prices - at least for a time.
The euro's weakness in 1999 and 2000 boosted relative Irish inflation in the early years of the millennium, but the currency's steady appreciation in 2002 and 2003 has acted as a deflationary influence of late, with more expected in 2004.
Specifically, I expect Irish inflation to fall to 1.5 per cent by March on the domestic consumer price index measure, but to rise from there to more than 2 per cent by the summer, not least because last year's series of mortgage rate cuts will cease to flatter the inflation calculation.
Nevertheless, an average inflation rate of 2.2 per cent for the year looks plausible, with a similar figure likely on the harmonised measure, which will bring the Republic much closer to the euro zone average, forecast at 1.8 per cent by the ECB.
