The State should set a target for the rate of growth in inflation, for example 2 per cent, and then co-ordinate policy to achieve this aim, writes Aebhric McGibney

The latest Consumer Price Index figures are to be welcomed as they show a significant decline in the rate of inflation to 4.2 per cent. More can be done and must be done, however, if price increases are to be brought into line with our European neighbours. On a harmonised basis, inflation in Ireland tops the EU at just over two-and-a-half times the average.

The original spur to the rise in inflation back in 2000 was largely externally driven. The euro was weakening and many of Ireland's imports are from countries outside the euro zone. A weaker euro meant the prices of imported goods were higher. Ireland has the most exposure to exchange risk outside of the euro area of all euro- zone members so Ireland took more of a price "hit" from the weakening euro. Rising oil prices also added to inflationary pressure.

Many of the external factors driving inflation have dissipated and indeed are working in Ireland's favour. The euro is appreciating. And yet, inflation remains high. A mindset of high inflation is embedding itself into the economy. The present drivers of inflation are in the sheltered non-traded service sectors of the economy. Prices in these sectors have grown by between 7 and 10 per cent over the past year.

Domestic factors are pushing up prices in the services sector. Government and the Social Partners can do something about it. IBEC has put forward a 10-point plan to help tackle the problem. Government should set a target for the rate of growth in inflation of, say 2 per cent, and then co-ordinate policy in taking the appropriate actions to achieve this target. Actions are required on pay, insurance, public spending, competition, infrastructure bottlenecks and consumer awareness.

A major cost component of any service business is the cost of labour. A business facing rapidly rising wages will seek to recoup the cost through price increases, where possible. Wage growth drives up inflation, which in turn drives up wage demands. Many remember the futility of the wage price spiral of the 1970s. Such an exercise need not be repeated.

Wage settlements in the public and private sectors must not exceed the levels obtained in other euro-zone countries.

It must be clearly understood that the 2 per cent target rate of inflation is the reference rate for pay bargaining. Any increases in excise duties on tobacco products should, by agreement, be excluded from the Consumer Price Index used as the reference for pay negotiation purposes.

Recent increases in insurance costs have also driven up inflation. The recent report on motor insurance has identified many actions that need to be taken. Similar actions need to be taken in other insurance areas. Additional providers must be encouraged into the market and vigorous action is needed to curb excessive court awards, legal costs, etc.

Another issue is public spending. Growth in public spending of 20 per cent per annum over the past two years has driven up prices. The supply of many goods and services is fixed in the short run. Extra spending does not always mean more goods and services - just more expensive ones. Controlling the growth in current public spending will require some important areas such as health receiving priority through reallocations from other areas. Productivity improvements will be required.

There is also a need to strengthen competition. Strong competition in the economy exerts downward pressure on prices, encourages responsiveness to customer demands and also promotes innovation. Competition is weakened either through State-imposed regulations, such as those that existed until recently in the taxi market and still exist for pharmacies, or can be limited by collusion among private companies. Greater competition in protected sectors, including the professions, can contribute to reducing inflation. A more aggressive approach to competition policy is required.

Another area which needs to be addressed is excessive transport costs which, through slow delivery, are ultimately borne by the consumer. Inadequate supply of accommodation raises prices and rents and fuels wage expectations. A greater quality and supply of roads, public transport systems and housing will help dampen price pressures.

The Competition Authority in co-operation with the Director of Consumer Affairs should also undertake regular examination of Irish prices compared with those in other EU member-states. Such a comparison may find that the prices of many Irish products are not out of line with those in other EU countries or are driven by cost pressures in Ireland, but that certain products are more expensive. Analyses of the reasons why these products are more expensive are likely to lead to a series of actions that could be taken to eliminate these reasons.

Finally, price awareness has probably been dulled by the prolonged boom period. Consumers must regain a sense of being price conscious.

Aebhric McGibney is a senior economist with the Irish Business and Employers Confederation