Much of the rise in inflation - to 4.2% - is caused by external factors according to the Government but a substantial portion is domestically generated, writes Pat McArdle

The latest Central Statistics Office data reveal that consumer price inflation has crossed a new threshold, reaching 4.2 per cent in July. This is the highest rate since April 2003.

It was well above the consensus expectation of 4 per cent and will pose further problems for the Government and the social partners as they ratify the recently negotiated wage agreement Towards 2016 and face into the last pre-election Budget.

It will also be unwelcome to consumers and the general public, particularly pensioners and others on fixed incomes, who will find their spending power eroded by higher prices.

The causative factors of the latest increase can be split into three broad categories - interest rates, energy prices and a residual, miscellaneous, category. The first two are by far the most important and, moreover, are outside the control of the Irish authorities.

We include mortgage interest rates in our consumer price index (CPI) basket so as to reflect changes in the cost of accommodation. This is done by constructing a notional national mortgage and an associated monthly annuity repayment.

The average annuity payment - no allowance is made for newfangled things like interest-free loans - rose by a massive 33 per cent in the year to July, adding almost half a per cent to the rate of inflation.

About two-thirds of this reflected higher mortgage rates and the remainder the impact of increasing house prices and the larger borrowings they gave rise to. Rents are also taken into account but they were unchanged in July and up only 5 per cent on an annual basis.

Energy made only a minor contribution to inflation in July. Energy prices rose by just under 1 per cent and were up 10.4 per cent on a year ago. In July, the average price of a litre of petrol was €1.18, up one cent on a month earlier. Energy added just under 0.1 per cent to the July rate. However, as the more recent scares have yet to be reflected in the pump prices, we can look forward to more bad news on this front in coming months.

There will also be an additional delayed effect as earlier moves filter through in the form of higher gas and electricity prices, though most of these will not materialise until early next year.

The importance of these "external" categories is best revealed by looking at the core rate of price increase - ie that excluding both energy and interest rates. On this basis, inflation in July was 2.1 per cent, up from 2 per cent a month earlier and double what it was in July 2005.

While the Government can say that it has no control over external factors, it cannot say the same of this figure. Neither can domestic forecasters, who have generally been caught unawares by the scale of these core increases, both in the year to-date and in the month of July.

It is interesting, therefore, to look at where the pressure is coming from. The rise splits roughly equally between food (partly weather-related), package holidays, accommodation and a residual category, the most notable item in which is insurance.

Even though house and car insurance rates are still falling, this is more than offset by health premiums, which are up 12 per cent with further rises in the pipeline.

In the main, these are services. Consumer confidence is poor, reflecting energy and interest-rate factors but spending on the, largely discretionary, items listed above is vigorous enough to allow service providers charge higher prices.

This is the weak spot in the official case that higher inflation is all down to external events over which we have no control.

It is true that much of the rise is external but a substantial portion is domestically generated.

This also shows up in the separate, harmonised, inflation measure used by the EU.

On a comparable basis, Irish inflation was 2.9 per cent in July compared with 2.5 per cent in the euro zone. Last January, the two were virtually identical.

An interesting aspect of the CSO data was the information on food prices, which have risen strongly so far this year, both here and abroad. The Irish data, however, covers a period in which the infamous Groceries Order was lifted.

In general terms, both prices of food products which were subject to the Order and those which were not, increased steadily, giving rise to criticism of its abolition.

The official response has been that it is too soon to judge. The latest data gives some sustenance to this view. In July, products subject to the Groceries Order recorded their first fall since its abolition, albeit that it was only 0.1 per cent. We shall see.

The outlook for the remainder of the year is no less problematical. It will continue to be heavily influenced by interest rates.

If, for example, there are three more quarter point rises between now and early next year - an assumption that is already priced into markets - the consumer price index rate will be one percentage point higher that otherwise.

Until recently, there was a general assumption that oil prices would gradually fall back. That no longer looks likely; instead, we are steeling ourselves for further rises. Bord Gáis, the ESB and the VHI are all looking for substantial price increases.

On a more optimistic note it seems unlikely that the Budget will exacerbate things by adding to duties on the old reliables. It might even lower some of them but I have not factored this into my forecasts.

Put all these together and it is not too difficult to see inflation hitting 5 per cent by end year and 5.5 per cent early in 2007.

The associated average rates of increase would be 4 per cent in 2006 and 4.5 per cent in 2007.

This will make life more difficult for Minister for Finance Brian Cowen. Last December's Budget was crafted around a 2.7 per cent CPI rate this year and 2.5 per cent in 2007. The more recent wage agreement assumed only slightly higher figures.

Higher domestic inflation is obviously bad for competitiveness and makes it more difficult to export.

It will increase pressure on the Government to compensate taxpayers and social welfare recipients by means of more generous indexation provisions in the next Budget. With the IMF calling for restraint in spending and an election looming, the timing could be better.

• Pat McArdle is chief economist at Ulster Bank. Views are personal.