THE Central Bank is caught in a bind. Despite a sure footed performance over the last few years in managing to control inflation in a fast growing economy, it must now guard against falling at the final hurdle and risking Ireland's entry into the single currency.
Ireland looks on course to qualify for the single currency. The main danger to our qualification would be a pick up in the rate of inflation. On an EU harmonised basis, inflation here is running at 2.1 per cent. To meet the Maastricht rules, inflation must be no more than 1.5 percentage points above the average of the lowest three rates in the EU - about 2.5 per cent at the moment.
There appears no immediate danger of a sharp rise in inflation. But, with the economy growing so strongly, the Central Bank will be on the alert as it is next year's rate which counts towards qualification for the single currency. The latest weakening of the pound against sterling thus creates an unwelcome inflationary threat.
The most important determinant of inflation is our exchange rate. A strong pound, particularly against sterling, keeps import prices from Britain low. Weakening of the pound could thus lead to a rise in import prices, which would feed through to inflation.
The pound is still strong on a trade weighted basis - in other words against an average of our trading partners as weakness against sterling has been matched by strength against other currencies such as the deutschmark. But much of the imports from states other than Britain are raw materials mainly used by multi nationals for export, which do not really affect Irish consumer prices.
Sterling is the important currency where consumer prices are concerned. And the authorities are rightly worried about this.
To keep the lid firmly on any inflationary pressures, the easiest option for the Central Bank would be to do what it can to encourage the currency to rise. However, this raises further problems. It is practically impossible for the Bank to push the pound up against sterling without affecting its rate against the D mark.
Too sharp a rise against the D mark would also be unwelcome at the Bank. This is because the Maastricht Treaty calls for stable currencies, and although no limits are specified, most observers presume this means the currency should trade within the old 2.25 per cent band against the D mark.
A few weeks ago it looked just about possible to keep a cap on the pound against the D mark, without seriously risking imported inflation from Britain. Of course, the other reason the Bank was selling was an ultimately doomed attempt to prevent a revaluation of the green pound which will cut the value of farmers intervention payments. This battle has now effectively been lost.
But sterling's rapid rise in recent days, given an extra boost by the interest rate rise on Wednesday, has caught the Bank on the hop, along with all the market analysts.
Should the Bank aim to allow the currency to trade below parity against sterling or allow it to rise against the D mark? A strong currency within the ERM may be a less unpalatable option on Dame Street, given the primary importance on holding down inflation. Even with that the balancing act will be very difficult, with the Bank only able to influence the currency's value rather than control it.
The real testing time for the Bank could come next month. The final Dublin Summilis expected to generate a fresh wave of convergence trading investments in states expected to qualify for monetary union by again underlining the political push to monetary union. If the bond market is flooded by a fresh wave of international money, there will be serious downward pressure on rates.
Add a weakening pound and pressure for lower rates to a pre election Budget expected next January and the Central Bank will know that meeting the Maastricht inflation rules cannot be taken for granted.
