It's hardly surprising that the Irish inflation rate for February of 4.6 per cent, on an EU standardised basis has been making headlines recently. But what is more surprising, is the marked contrast in attitudes between the authorities here and in Frankfurt and Brussels.
The Minister for Finance, Mr McCreevey's main concern appears to be the possible impact on the national wage agreement. And even that is some way off, as the unions have only voted this week to accept the package - so any renegotiations of the terms are not even on the horizon, no matter what some individual union leaders say.
But in Brussels the attitude is very different. The EU Commissioner for Monetary and Economic Affairs, Mr Pedro Solbes, has explicitly called for fiscal or tax and spending tightening. He has not gone so far as to say taxes should be raised or current spending cut, but he has said that increases should be forgone. European Central Bank President, Mr Wim Duisenberg, appears to have a similar, although far more nuanced message. He too has cast doubt on the wisdom of pay increases and tax cuts. But are they right?
Apparently not, according to new research from Dr Dan McLaughlin, chief economist at ABN Amro. Using a well-known economic model, the UK's National Institute's Global Economic Model (NIGEM), which the ESRI also uses, Dr McLaughlin found that the stratagems outlined by the EU officials simply would not work. Inflation would be only 0.2 per cent below what it otherwise would have been. An alternative would be a cut in Government spending, and in this case a £300 million expenditure reduction would reduce inflation by slightly more, some 0.5 per cent by the second year. But as Dr McLaughlin points out this seems small beer for cutting spending by the equivalent of the whole of the spending increase announced by Mr McCreevey in his 2000 Budget speech.
The reasons for this are reasonably well-rehearsed. The EU officials appear to be making the mistake of comparing the Republic with the far larger economies of Continental Europe, particularly France and Germany. For these economies the standard response to a rise in inflation is a rise in interest rates. The alternative is of course a tighter fiscal policy. The ECB has already responded to growing EU-wide inflation by putting up interest rates which have now risen by a full percentage point to 3.5 per cent over the past year.
But the problem is that in contrast to France and Germany, relatively closed economies, the Republic is extremely open and both imports and exports account for almost 100 per cent of Gross National Product. In the euro zone as a whole imports only account for 12 per cent of GDP.
In this economy, prices are determined more by world price trends and the exchange rate, particularly as a small, open economy which simply does not have the muscle to set prices globally. As a result it is the value of the euro which ought to have the biggest impact on our inflation rate.
This in itself, however, has proven to be a bit of a puzzle in recent years. The trade-weighted index of the pound has fallen by 8.5 per cent since the euro came into being. But it is only in recent months that even a modest exchange-rate effect can be seen in the inflation figures.
According to Mr Jim O'Leary, chief economist at Davy Stockbrokers, who has his own model of Irish inflation, up to the end of last year the declining value of the euro had no impact whatsoever on traded goods. Since then the figures have begun to feed in a little.
Between April 1999, the most recent trough in the CPI, and February this year, inflation excluding mortgages had risen from 2.3 per cent to 4.8 per cent. According to Mr O'Leary, energy had contributed half of this rise as energy prices had accelerated to 12.1 per cent, and tobacco contributed 0.7 of percentage point of the 2.5 points rise. So together both explained 2 points of the 2.5 points increase.
Volatile foods, which he generally ignores as they move around a lot, took 0.3 of a point off. But traded goods, which includes alcohol, accelerated from 1.4 per cent to 1.9 per cent, contributing 0.3 of a point, a relatively small amount.
Importantly, non-traded goods which reflect increased demand as well as labour market tightness, contributed twice this much at 0.6 of a point.
The price rises in traded goods could be a sign that the exchange rate effect is beginning to feed through after a very long lag. But more fundamentally, according to Mr John FitzGerald, research professor at the ESRI, UK firms have simply changed their behaviour. They are now pricing in euros and holding their prices in euros. This he says is not likely to feed through as firms which increased prices would simply lose market share. After all, supermarkets can simply switch suppliers to a eurozone country. As result, according to Mr FitzGerald low prices are here to stay.
It seems the authorities here may well be right, although they will have to keep an eye on the non-traded or service inflation which is beginning to roar ahead.
