Domestic demand is set to fall in volume terms this year, a recent OECD report predicts, writes Paul Tansey.

THE PARTY'S over in the domestic economy. The building industry is at a standstill. The consumer boom has been put on ice. Last year's surge in personal spending, aided by the release of Special Savings Incentive Accounts, is a distant and receding memory. This year, the home economy will become smaller.

Domestic spending, the principal source of economic growth in the past five years, is set to fall in volume terms in 2008. In its recently published Economic Outlook, the Paris-based Organisation for Economic Co-Operation and Development (OECD) anticipated that real domestic expenditure would decline by 0.2 per cent this year.

The downturn in domestic demand was triggered initially by the steep decline in the fortunes of the construction sector. However, the weakness in construction is now seeping into other areas of the domestic economy, most notably consumer spending. This is important, since consumer spending is the largest component of domestic demand, accounting for 55 per cent of the total.

Consumer spending has taken a tumble in recent months. Retail sales volumes in April were 3.2 per cent below sales levels a year earlier, according to the Retail Sales Index published yesterday by the Central Statistics Office (CSO). Retail sales volumes in the first four months of 2008 were 0.8 per cent lower than in the same period in 2007. The sales slump has crystallised quickly.

The volume of consumer spending in the economy is primarily a function of the level of real personal income. If total real personal incomes in the economy rise, so too will real consumer spending.

The growth in real personal incomes depends crucially on two key factors: changes in the numbers at work, and changes in the purchasing power of individual income earners.

Between 1995 and 2007, the volume of personal consumer spending in Ireland more than doubled, rising by 106 per cent. Explosive employment expansion, rather than gains in the real incomes of those already at work, put the muscle in the consumer boom. Between 1995 and 2007, the numbers at work advanced from 1.28 million to 2.12 million, an increase of almost two-thirds.

However, the surge in Irish employment is running out of steam. The Quarterly National Household Survey (QNHS), published earlier this month, showed that employment growth has slowed to a trickle between the final quarter of 2007 and the first quarter of 2008.

On a seasonally-adjusted basis, the numbers at work increased by just 6,200 between the two quarters, a gain of less than 0.3 per cent, or 1.2 per cent on an annualised basis.

Moreover, the first quarter for the QNHS spans December to February and so broadly represents the employment position at mid-January 2008. Unfortunately, a lot of jobs have flowed under the bridge since that time. This is evidenced by both the trends in Live Register unemployment and in redundancies since the beginning of the year.

The Live Register figures for May show that, on a seasonally-adjusted basis, the numbers signing on have increased by 35,700 or by 20.8 per cent since the start of the year. While not strictly a measure of unemployment, the Live Register nonetheless provides a useful indicator of short-run changes in the numbers out of work.

The trend in redundancies provides a further indication of the softening in the labour market so far this year. In the first five months of 2008, the Department of Enterprise, Trade and Employment has reported the number of redundancies at 13,564, a 27.1 per cent increase on the corresponding period in 2007.

Thus, recent labour-market trends at best point to the cessation of employment growth this year, while a fall in the numbers at work is a more likely outcome.

Those already at work are fighting financial battles on many fronts at present. In the face of a weakening labour market, the Economic and Social Research Institute (ESRI) anticipated that the pace of wage growth would decelerate this year. In its latest Quarterly Economic Commentary, the institute reckoned that money wages would rise at an average rate of 4 per cent this year following an advance of 5.5 per cent in 2007.

If this forecast proves accurate, then wages will barely keep pace with prices this year. So far in 2008, prices have risen at an unexpectedly rapid rate, driven by soaring increases in food and energy costs. In the 12 months to May, the Consumer Price Index has registered an increase of 4.7 per cent, while food prices have risen by 8 per cent. Excluding mortgage interest, the underlying inflation rate was running at 3.7 per cent in the year to May 2008.

With price increases confiscating most of the addition to purchasing power conferred by rising wages, ordinary households have been left with little or no real income growth with which to finance increases in the volume of their purchases.

Moreover, the urge to step up spending has been dissipated by two psychological factors. Firstly, the steep fall in house prices has diminished the wealth of most households over the past year, since their homes are their principal assets. Such negative wealth effects may cause consumers to rein in their current spending this year.

And secondly, consumer confidence has ebbed away due to the continuous flow of grim economic news and increased fears of unemployment. Again, this may trigger additions to precautionary savings, as cash is added to rainy-day accounts.

The major forecasting institutes - the Central Bank, ESRI and OECD - are all projecting real consumer spending growth in the range of 3 per cent to 3.4 per cent in their latest sets of forecasts, though some of these date back to March. In light of an employment standstill at best, minimal real wage growth for those at work, and a slide in consumer confidence, these forecasts now appear to be too high.

The available evidence certainly points that way. In addition to the slippage in retail sales volumes in the first third of the year, the exchequer returns for the five months to May show that VAT receipts were almost €600 million or 8.1 per cent short of budgeted levels.

These trends suggest that real consumer spending will be little better than flat in 2008. If this proves to be the case, then the downturn in domestic demand will be considerably more pronounced than expected.