Inflation is at its highest since 1984 and will only fall slightly next year, according to the latest quarterly commentary from the Economic & Social Research Institute (ESRI).

According to the institute, inflation will average 4.4 per cent in 2001 but only if the euro appreciates in value and oil prices stabilise. "The risks are on the upside," said the quarterly's author, Mr Danny McCoy. The spending Estimates published by the Government last month are seriously inflationary, Mr McCoy warned, and coupled with a give-away Budget next week could push consumer prices even higher. "Tax cuts adding to disposable income will have a significant inflationary impact through the housing channel," he said.

He added that the ESRI's view that tax cuts should be withheld in favour of deferred compensation has been strengthened by the expansionary nature of the Estimates for 2001.

However, growth is set to remain strong, aided by the weak euro and by strong domestic demand. The level of future growth will be determined by increases in female participation in the workforce and immigration as well as the strength of the euro. The ESRI has not yet predicted double digit growth but this is now very close at 9.9 per cent in terms of Gross Domestic Product for this year. This will slow next year as employment growth falls to 3.4 per cent and labour force growth declines to 2.7 per cent from 3.2 per cent this year. As a result GDP will slow somewhat to 7.3 per cent in 2001. Gross National Product which excludes repatriated profits from multinationals will be 8.6 per cent this year falling to 6.6 per cent in 2001. Unemployment will fall to 3.3 per cent next year from 4 per cent in 2000.

Average wages levels are also rising quickly and according to Mr McCoy will increase by 10.2 per cent in 2001, if the terms of Partnership for Prosperity and Fairness are not greatly exceeded in the public sector. The overall wage bill will start to outstrip income in 2001.

Non-agricultural wages will rise by 13.6 per cent this year and 14.4 per cent in 2001. National income will rise by 15.7 per cent before falling to 13.7 per cent next year.

Another problem, according to the ESRI, is the level of personal indebtedness which has risen to 64 per cent from just more than 40 per cent in 1990. However, most of this is made up of housing loans and it is still well below the levels in both the UK and US which are close to 100 per cent, according to Dr Dan McLaughlin, chief economist at ABN Amro.

Figures released by the Central Bank yesterday showed a 2 per cent increase in consumer lending in October. The adjusted year on year change in private sector credit rose to 24.2 per cent from 23.7 per cent the previous month.

Residential mortgage lending also rose 2 per cent in October to 18.3 per cent compared with 16.9 per cent in September. However, the Bank warned that the figures needed to be treated with caution because of the increasing number of mortgage securitisations.

According to Mr McCoy, the levels of indebtedness and the possibility that wages may now chase inflation means the economy is increasingly exposed and a recession is now an outside possibility. Labour shortages also mean the current partnership agreement is no longer workable. "The rigidities in the current agreement do not suit, will not hold and will not work," he said.

He added that the tight jobs market means tax cuts no longer mean wage stability and now simply feed into the housing market and erode competitiveness. "The most obvious solution is to let the free market prevail but we also need flexibility and wages must be able to rise and fall depending on the level of growth.

"There is no soft option. The contribution to inflation from domestic sources is on the rise and we are very exposed over the euro over which we have no control. Competitiveness can really suffer and in the worst case we could see a very rapid slowdown and possibly recession." He warned that there are now parallels to the 1970s when there were a couple of good years when the Government engaged in tax cuts and spending increases which seemed justified with low interest rates. The second oil price shock sent rates soaring and the Republic became "a third world country" almost overnight.

According to Mr McCoy there is some comfort this time with large Budget surpluses, but the economy is much more exposed to the euro rising or higher interest rates.