The economy will pick up next year but the loss of competitiveness suffered in recent years will continue to act as a drag on growth, according to the Central Bank.
Its latest quarterly bulletin, published yesterday, is predicting a modest upturn in gross national product growth to 3 per cent next year, from an estimated 2.25 per cent this year, as the Irish economy benefits from an international recovery.
The medium-term outlook is "reasonably favourable", it says, provided there is no further erosion in competitiveness.
Competitiveness has been eroded in recent years as inflation outstripped the EU average, the Bank warns, with prices here now 12 per cent above the EU average.
Over the past 18 months, the euro's rise in value has intensified the squeeze on exporters.
The index the Bank uses to monitor the impact of prices and currency moves shows that the Republic's competitiveness has worsened by 14 per cent since joining monetary union in 1999.
"It is not just that we have lost our competitive edge - we have lost competitiveness in absolute terms," according to Dr Michael Casey, the Bank's assistant director general, speaking at the launch of the report yesterday.
The bulletin emphasises the importance of maintaining the recent declining trend in inflation so as to reach the 2 per cent target set by the European Central Bank (ECB) for the euro area. However, Dr Casey said that, in addressing the losses in price competitiveness of recent years, "we are between a rock and a hard place", as trying to drive inflation below the low level of our EU partners to restore the losses of recent years could risk a move to deflation.
So far the performance of the jobs market has been encouraging, the Bank says, "however, wage costs in several sectors have shown signs of picking up again and this is a worrying development".
The other immediate competitive risk identified by the Bank is a further rise in the euro's value.
Despite these difficulties, it says "there is some evidence of recovery in the Irish economy". The economy has displayed "resilience and flexibility" in the relatively difficult environment of recent times, it says. The Bank is encouraged by the recent moderation of inflation - which fell to 2.2 per cent in November - but expects it will run at 2.75 per cent next year on average, still above the 2 per cent target rate set by the ECB for the euro zone.
The Bank is reasonably optimistic about the medium-term outlook. The potential output growth level of the economy is 4-5 per cent, it says, reflecting strong labour supply and productivity growth associated mainly with the high-tech sector.
However, Dr Casey said the continued attraction of a strong flow of inward investment could not be taken for granted, with the risk of many projects going to the EU accession countries.
