Domestic services sector inflation is outstripping overall increases and needs to be tackled after the election, writes Paul Tansey

Ireland is an expensive country and it's growing dearer by the day. The annual rate of consumer price inflation again topped 5 per cent in March and the principal force driving prices higher is the rate of inflation in the domestic services sector.

On average, Irish consumers spend more than half of their household budgets on services. Over the past year, the average price of services in Ireland has risen by 9.3 per cent. Unlike goods, domestic services are largely insulated from foreign competition.

The rate of increase in average Irish prices continues to outpace inflation rates in the economies of Ireland's principal trading partners. The continued deterioration in Irish costs and prices relative to the rest of the world is damaging Irish businesses, threatening Irish jobs and undermining the economy's future prospects for growth.

The ability of Irish businesses to maintain market share at home and abroad is being further compromised by the weakness of the dollar. Uniquely among members of the euro zone, Ireland's two principal foreign markets - the US and Britain - lie outside the euro zone.

In effect, Ireland's excessive inflation relative to its trading partners combined with the depreciation of the dollar is leading to a continuous and unwanted appreciation of Ireland's real exchange rate.

Ireland's ranking as among the most expensive countries in the euro zone precedes the formation of the current Government. A study published by Forfás in June 2002 found that "consumer price levels in Ireland are now the second highest in the euro zone". This finding, however, did not soften our inflationary cough.

Average prices rose faster in Ireland than in any other member of the euro zone in the year to March 2007, according to price data recently released by Eurostat. On a harmonised (HICP) basis, and excluding mortgage interest, average Irish prices were 2.9 per cent higher in March 2007 than a year earlier. For the euro zone as a whole, average prices in March 2007 were 1.9 per cent above the levels prevailing a year earlier.

Taking the last five years together, Ireland's inflation rate has been half as high again as the average rate of price increase in the countries with which we have formed a single currency.

As a result, Ireland has become the most expensive country in the euro zone and the second most expensive in the European Union. Since the Government took office in 2002, the general level of consumer prices in Ireland has risen by almost one-sixth. Moreover, since mid-2005, the overall inflation rate has gathered pace. The average rate of retail price inflation has edged up from 2.1 per cent in the year to June 2005 to 3.7 per cent in the year to June 2006 and has now reached 5.1 per cent in the 12 months to March 2007. These trends are illustrated in Table 1.

From 2002 onwards however, the story of Irish prices has been a tale of two inflation rates. Irish consumers divide their spending almost equally between goods and services.

As Table 1 demonstrates, inflation in the goods sector has been subdued, while the speed of services inflation has been breathtaking.

Between June 2002 and March 2007, the average price of goods bought by Irish consumers increased by just 4.5 per cent, or by less than 1 per cent a year. Over this period of four and three-quarter years, the average price of food and soft drinks rose by just 2.3 per cent, while average clothing and footwear prices actually fell by 14.8 per cent.

It has been a very different story in the services sector. Since mid-2002, the average price of domestic services has risen by 27.3 per cent. In the last 12 months alone, the price of services has jumped by 9.3 per cent. Services include electricity, public house prices, gas, telecommunications, medical fees, meals out, housing, rent, mortgage interest repayments, insurance, public transport, entertainment, recreation and childcare.

To put it another way, inflation in the domestic services sector has accounted for more than 85 per cent of the total rise in average prices facing consumers during the period spanning June 2002 to March 2007.

This is not simply a statistical exercise. Ireland's two-speed inflation rate reflects a deeper duality in the nature and functioning of the economy. It also provides clear pointers to those aspects of current performance requiring immediate attention.

In the goods quadrant of the economy, inflation has remained persistently low. This is explained by the fact that almost all goods are traded internationally. Where Irish-made goods are deemed too expensive by Irish consumers, they will simply switch to buying cheaper imported substitutes, an alternative made easier by increasing trade liberalisation.

Consequently, inflation remains very low in goods markets, as cheap imports are substituted for more expensive, home-produced products.

This is good for consumers' wellbeing. But there is a real cost, measured in the sales and jobs lost by indigenous manufacturers.

The domestic services sector, on balance, is much better insulated against foreign incursions. Even allowing for the substantial growth in internationally-traded services, the domestic services market is largely non-traded.

While often strongly contested by a range of domestic suppliers, the domestic services market usually does not face foreign competition. Plumbers and accountants, hairdressers and solicitors are unlikely to see their regular Irish clients deserting them for foreign competitors in Boston or Berlin.

The very rapid increase in the average price of Irish services in recent years is attributable to three separate factors.

First, the Government has allowed very significant increases in the prices charged to the public for services that it administers. From data published in the most recent Quarterly Bulletin of the Central Bank, it can be estimated that the price of such administered services increased by 37.1 per cent between 2002 and 2006*.

These administered prices include local authority charges and rents, public transport fares, hospital charges and health insurance charges.

Second, the domestic services sector is both labour intensive and, on average, exhibits low productivity growth. Domestic service providers source almost all of their inputs - labour, public utilities, rents and professional services - from the home economy. They have thus been exposed to the full weight of the increases in domestic costs, wages and prices that have materialised since Irish inflation began to accelerate again in 2000.

Paradoxically, as extensive users both of labour, public utilities and business services, service businesses themselves have been among the principal victims of high service sector inflation.

Moreover, because average productivity growth in services is relatively low, there has been little scope for containing the growth in final prices by raising output per worker.

For most domestic service-based enterprises, the bottom line shows that, in large part, the price increases they introduced broadly reflected the cost increases they sustained.

But, in the third case, and notwithstanding rising costs, service providers also put up their prices because they could. In conditions of excess demand, businesses raise their prices.

They do so in the knowledge that consumers will be prepared to pay the higher price to secure guaranteed access to the service that they require.

The Central Bank makes the same point more politely if more obliquely, stating that "strong domestic demand growth . . . enabled many firms in the non-traded sectors to increase the wage/price mark-up".

As a result of this inflationary surge in services by 2005, the average level of services prices in Ireland had risen some 23 per cent above the average price of services in the countries comprising the then EU-15.

This punishes Irish consumers as well as penalising Irish businesses operating in the traded sector of the economy. For the prices of many services to consumers - from electricity, gas and water to insurance costs and legal and accounting fees - are also input costs to Irish businesses.

However, Irish businesses engaged in the traded sector, whether challenging imports on the home market or seeking to sell abroad, do not enjoy the luxury of marking up their prices to compensate for excessive services inflation in Ireland.

The prices that they can charge for their output are set by world markets. If they cannot match world prices, then they either cut their profit margins or retire hurt from the market.

Unfortunately, this is precisely what is happening to many Irish enterprises trying to trade on world markets at present. They are being ambushed from behind by the high rates of inflation at home, stemming principally from the services sector.

This deterioration of Irish competitiveness on international markets is not a theoretical construct. It can be substantiated. Ireland's share of world exports has fallen from 1.45 per cent of the total in 2003 to 1.23 per cent in 2006, a decline of 15 per cent in three years.

Reviving Irish competitiveness will be the major economic task facing the incoming government, whatever its combination of political hues.

Competitiveness can be restored by simultaneously containing inflation and speeding productivity growth. The absolute rate of Irish inflation should decelerate gradually over the next 12 months. But what matters for price and cost competitiveness is Ireland's inflation rate relative to trade rivals.

The best way of achieving such convergence on inflation is to steer the economy towards a slower annual growth rate, perhaps in the region of 4 per cent annually, somewhat below its productive potential. Of itself, slower growth would encourage a greater intensity of competition, hence relieving upward pressure on prices in the services sector.

This should be buttressed by a comprehensive review of the prices government and its agents charge for the services they administer.

What the economy must avoid at all costs is a major, fiscally-induced expansion of demand as an incoming government seeks to redeem its election pledges at the public expense.

That road to perdition was travelled in 1977. Under no circumstances should it be visited again.

• Ireland's Competitive Performance, Mark Cassidy and Derry O'Brien in Quarterly Bulletin No 2, 2007, Central Bank, pp 93-127