Overly high expectations regarding pay, public spending and tax reductions pose the biggest threat to maintaining the strong growth rate of recent years, according to the latest report from the ESRI.
In its Quarterly Economic Commentary, the ESRI says the negotiations on a new partnership agreement will be the next major milestone in the economy's progress. But any new agreement must recognise the uncertainties that the economy faces and the change in economic context brought about by the single currency.
"EMU membership means that any overshooting in the rate of wage inflation will be severely punished," the ESRI says. "The wage formation process should, therefore, build in flexibility mechanisms such as profit-sharing or gain-sharing."
The report also says that there is a limit to the scale of tax cuts or new spending plans that can be safely implemented.
It warns that inflationary pressures in the economy mean that there is no further scope for fiscal expansion next year to help secure an agreement. Bargaining on next year's pay rates must be conditional on the tax package already announced, it says.
The report also says that a long-term perspective in determining pay settlements is essential to avoid creating rigidities which could lead to severe employment losses in the future.
For the moment, however, the employment outlook is rosy. Growth in the numbers at work this year was stronger than expected, with employment up by 82,000 or more than 6 per cent in the first half.
As a consequence, the ESRI expects the annual average unemployment rate to drop to 5.25 per cent in 1999, a level that was not expected to be reached until much later. Limitations on labour supply are likely to mean that employment growth slows next year, increasing by an annual 51,000, but the jobless rate is still set to drop below 5 per cent in 2000.
The strong employment growth seen this year has prompted the ESRI to raise its GNP forecast for 1999 to 7.25 per cent from its earlier estimate of 6 per cent. It expects a slight slowdown next year, to 6.25 per cent.
Aside from the pay talks, the ESRI's biggest concern is the inflationary pressures in the economy, which it believes were further fuelled by the recent Budget.
"The Budget was more expansionary than we would have liked," said Mr David Duffy, one of the authors of the report. The ESRI notes that a more prudent policy might have been to forgo some tax cuts next year, according top priority to investment expenditure instead.
Although the consumer price index is forecast to rise by just 1.5 per cent on average this year, increasing to 3 per cent next year, the ESRI says wider measures of inflation are likely to be much higher.
It believes the consumer price index may underestimate the underlying rate of inflation because of its handling of the costs of housing.
The institute is also concerned that by further stimulating demand, the Budget may have rendered the economy more vulnerable to future external shocks.
Although it expects the economy to enjoy a "soft landing" in the early years of the next decade, the ESRI says there is a danger that unexpected world events could produce a sudden deflation of domestic activity.
"The Budget, by raising the level of economic activity and of prices even higher, could make a future `hard landing' harder still," it says.
