Having climbed to 7 per cent in November, it seems almost inevitable that Irish inflation will ease considerably in the next couple of months. I expect a rate comfortably below 6 per cent to prevail early next year with a further moderation producing an average inflation figure of just under 5 per cent for 2001. Faced with this prospect, it might seem natural to breathe a sigh of relief and proclaim the worst is over on the inflation front. Unfortunately, the Irish economy could be very vulnerable if inflation falls sharply in the coming year.
To understand the risks to the Irish economy from lower inflation in the year ahead, it must be remembered why inflation has surged in the past 12 months. First of all, the external backdrop has been very unhelpful; oil prices increased dramatically. The euro tumbled and interest rates rose sharply. However, there has also been a substantial domestic element boosting inflation. Last December's Budget decision to raise cigarette taxes added about three-quarters of a percentage point to the Consumer Price Index. More fundamentally, the extraordinary strength of the Irish economy has substantially raised the prices of domestically produced goods and services ranging from haircuts to housing costs, from childcare to motor repairs. Looking forward to 2001 we must assess whether price pressures are likely to ease right across the board or imbalances emerge that might threaten the longer term outlook for the Irish economy.
One pointer in this regard might be the divergent evidence coming from two other economic indicators published yesterday. In Germany, the closely watched IFO survey of business confidence slipped again, continuing a declining trend evident since May. That the Euro zone's most substantial economy might be weakening should not come entirely as a surprise. In recent weeks a succession of indicators have suggested that activity in the US economy was dipping sharply. If the lynchpin of global growth for the past decade falters, Europe will struggle to retain any significant momentum. The outlook for the Euro zone economy may be further darkened by a recovery in the euro because faltering retail activity and sliding equity markets on Wall Street have lessened investors appetite for the US dollar.
The combination of a weakening global economy and a stable or possibly stronger euro looks set to impart a substantial deflationary impulse to Ireland in the year ahead. Unfortunately, it is likely to do so in a threatening manner. The external backdrop implies softer demand in Ireland's export markets but, more importantly, it will intensify competitive pressures. This may come at a time when developments within the Irish economy suggest the possibility of increasing domestic price and cost pressures. In this context, the other significant indicator released yesterday was the October figure for Irish retail sales. An annual increase of 10.6 per cent, together with a strong monthly rise suggests a bumper Christmas spending season lies ahead. Moreover, if the world economy does weaken dramatically, Irish households spending power will be further enhanced by stable or falling interest rates. With income growth accelerating and a massive budget stimulus in prospect it is difficult to imagine domestic pressures on prices and costs not increasing in the year ahead.
ON balance, it is more than likely that the strong deflationary impulse from weaker global activity and a healthier euro will more than offset rising domestic pressures next year. As a result, Ireland's inflation rate should fall. This drop is likely to mask a deterioration in the underlying position of the Irish economy. Put simply, downward pressure on costs abroad and rising costs at home cannot be sustained indefinitely.
Unless current upward pressures on domestic costs reverse - an outcome that seems unlikely in the near term because of the exceptional momentum in spending - the Irish economy could suffer a significant deterioration in competitiveness next year. If the global economy does weaken substantially and the euro sustains its recent rising trend, the risk of a notably weaker outlook for activity and employment in the Irish economy in 2002 and beyond could increase significantly.
Austin Hughes is chief economist at IIB Bank
