While the Government can do little about rising oil prices, steps can be taken in other areas to ensure that inflation is contained, writes Alan McQuaid

With the global economy stumbling along on the road to recovery, the last thing the world needs now is a war between the US and Iraq, which would inevitably lead to conflict in the Middle East. The region accounts for two-thirds of the world's oil supplies.

There is no doubt that a pre-emptive US strike on Iraq would cause oil prices to spike, at least until oil markets feel sure that neighbouring facilities in Kuwait and Saudi Arabia aren't threatened and that these and other exporters are fulfilling their pledges to make up for lost Iraqi production.

In addition, the US, the world's largest consumer of oil, could open the door to its strategic stockpile and seek a wider release of stocks held by other industrial countries that are members of the Paris-based International Energy Agency.

But, quite clearly, taking Iraq out of the equation at this point is extremely troublesome. Oil inventories are low at the moment and will get squeezed further with the high-oil-use months of winter just around the corner. However, members of the Organisation of Petroleum Exporting Countries (OPEC) have more idle capacity, compared with two years ago, to replace lost supplies.

That said, with the international price of a barrel of oil rising from $23 to $30 in the past couple of weeks just on the talk of war, God knows what will happen to oil prices if an attack by the US on Iraq does actually take place.

The OECD estimates that every $5 rise in the cost of a barrel of oil takes 0.1 percentage point off economic growth and adds 0.2 percentage points to consumer prices. As such, it will need quite a hefty rise in the price of oil to do serious damage to the global economy.

Nonetheless, experience tells us that higher energy prices do impact negatively on the economy. Oil prices have jumped a third already this year and the cost of a barrel of oil is more than two-and-a-half times dearer than it was at the end of the 1990s.

From an Irish perspective, the immediate impact of higher oil prices will be seen through an increase in energy prices (electricity, gas, other domestic and transport fuels) in the consumer price index (CPI). The last major surge in oil prices was in 2000.

That year, energy prices within the Irish CPI rose by 13.6 per cent on average, which was a main contributory factor in Ireland's headline inflation rate hitting 7 per cent in November that year, its highest level for 16 years. After falling back on average by 2.6 per cent in 2001, energy prices within the CPI have risen 1.7 per cent on average year-on-year in the first half of 2002, a relatively small rise.

However, one can safely say that an attack on Iraq would push up the average increase much higher than this. Energy prices within the Irish CPI account for 6.4 per cent of the total index, so an average increase of 5 per cent in energy prices would add 0.3 of a percentage point on to the Republic's inflation rate. This would occur at a time when Ireland has the highest rate of inflation within the euro zone, and when the headline rate of increase remains stubbornly above 4 per cent.

Therefore, it is imperative the Government does its best to keep inflation under control. While there is little the Government can do about external factors like international oil prices, there are steps that can be taken in other areas to ensure that inflation is contained.

For instance, fiscal policy (higher taxes) has an important role to play in constraining domestic demand. There is also the issue of sanctioning price rises for semi-state companies without assessing their knock-on implications for inflation.

The risks remain very much to the upside in the short term, with VHI and third-level education increases on the way in September, and the probability of rises in domestic electricity, and another hike in the television licence, not too far off.

Furthermore, it is difficult for the Government to criticise private retail and service providers for higher charges, when it itself is sanctioning price rises. In simple terms, the Government needs to take corrective action on inflation quickly, especially with the threat of higher oil prices, if the economy is to remain competitive.

Of course, Ireland and the rest of euroland suffer a double blow with rising oil prices as oil is priced in dollars on the international market and, despite its recent gains, the euro is fundamentally weak against the greenback.

The other main worry is that higher inflation will lead to increased wage demands at a time when the economy is in a slower growth phase. This is all the more reason for the Government to show leadership, because the last thing Ireland can afford to do is price itself out of international markets through higher wages.

Then there is the whole issue of whether the US economy is adversely affected by a military conflict. Anything that slows the economic recovery in America would be bad news for Ireland, given our high dependence on US multinational companies. A further US slowdown would mean more bad news in terms of job lay-offs, as seen in Carlow in the past week with the Braun announcement. Nor is there any guarantee that Irish consumers will get any respite from lower interest rates.

While both the Federal Reserve and the Bank of England would most likely respond to weaker economic growth as a result of higher oil prices by cutting interest rates further, the European Central Bank, unlike its Anglo-Saxon counterparts, is more preoccupied with keeping inflation under control rather than boosting growth.

As such, there is as much chance of rates being raised as being cut if euro-zone growth falters but inflation rises. While I think the US economy will manage to recover slowly but surely in the coming months, even with the possibility of a military conflict with Iraq, there is a danger that the global economy will stall. From Ireland's viewpoint, it is essential that all the social partners recognise the difficulties, and make prudent and sensible decisions to ensure Ireland's economic well-being.

Alan McQuaid is chief economist at Bloxham Stockbrokers