Rising inflation is rapidly eroding the purchasing power of increases in wages won this year, writes Paul Tansey.

Rising mortgage interest costs were responsible for more than half of the Republic's 5 per cent headline rate of inflation in the year to July 2007, according to figures released yesterday by the Central Statistics Office (CSO).

Mortgage interest repayments increased by an exceptional 43.7 per cent in the 12 months to July.

This mirrored almost precisely the rise in euro-zone interest rates over the period.

The European Central Bank (ECB) has raised interest rates on five separate occasions since July 2006. In consequence, key eurozone interest rates have risen from 2.75 per cent to 4 per cent.

Irish home buyers are now paying a very high price for the ECB's counter-inflation strategy.

Repayments of mortgage interest absorb about 6 per cent of average household expenditure in the Republic. As a result, and by itself, the 43.7 per cent increase in mortgage interest costs borne by households over the past year raised the national level of prices by 2.56 per cent. In so doing, it accounted for more than half the 5 per cent headline inflation rate seen in the past 12 months.

But mortgages were not the only housing product to have increased in price over the past year. Rents have risen by 10.8 per cent during the year. Reflecting rising international energy costs, natural gas prices have been levered up by 20.5 per cent over the past 12 months, while electricity is 12.6 per cent more expensive than it was a year ago. In last December's budget, the Department of Finance projected that the headline rate of consumer price inflation (CPI) would average 4.1 per cent in 2007.

Yet, month after month this year, the annual rate of headline inflation has remained persistently about 5 per cent. This is generating two adverse economic effects.

First, with rising mortgage costs the principal cause of unexpected inflation this year, home buyers are finding their budgets stretched to the limit.

Moreover, the steep incline in mortgage rates is reducing the affordability of house purchases among potential home buyers.

With further rises in ECB interest rates expected in the autumn, affordability is set to decrease again in the months ahead.

In short, rising mortgage rates are dampening the demand for housing among potential buyers.

Against this interest rate background, no recovery in housebuilding is imminent.

Secondly, rising prices are rapidly confiscating the purchasing power of wage increases won this year. In its most recent Quarterly Bulletin, the Economic and Social Research Institute (ESRI) forecast that average wages would rise by 5.5 per cent in 2007.

With the Central Bank now forecasting an average headline inflation rate of 5 per cent this year, this implies that real wages on average will rise by just 0.5 per cent in 2007.

In these circumstances, employees may gain more real purchasing power this year from the tax cuts and enhanced transfer payments delivered in the 2007 budget than from their real incomes from employment.

But the sting in the tail is the impact of high inflation on future wage growth. The ESRI has run a regression equation relating growth in the CPI in one quarter to wage growth in the following quarter. It found that the pass through from prices to wages was both high and rapid, stating that "according to the equation, 50 per cent of the increase in the CPI is reflected in wage increases within three months".

Should this relationship hold into the future, then high headline rates of inflation will ensure that earnings in the Republic continue to rise at a faster pace than in the euro zone, with damaging effects on Irish cost and price competitiveness.

In the Republic, ESRI data show that earnings growth averaged 5.2 per cent annually over the period 2003 through 2006.

Over the same period, the annual growth in earnings throughout the euro zone was less than half as fast, averaging 2.5 per cent. The deterioration in Irish cost and price competitiveness can be tracked by examining trends in the Harmonised Index of Consumer Prices (HICP), which compares inflation rates across the euro zone on a common basis.

Mortgage interest costs are excluded from the HICP measure of inflation.