Signs of global recovery have influenced thinking at the Central Bank, writes John McManus

Inflation, and wage inflation in particular, is now the most significant threat to theeconomy, according to the Central Bank.

Rising prices have replaced the global economic slowdown as the factor most likely to limit economic growth this year, Dr Michael Casey, the assistant director general of the Bank warned yesterday.

"We have to look seriously at the issue of domestic costs. It is the single biggest exposure that the economy has," he said.

The issue has started to gain prominence in the Bank's thinking as evidence mounts that the global economic downturn is coming to an end more quickly than anticipated. This, along with stronger-than-predicted domestic demand, has led the traditionally conservative Bank to increase its forecast for economic growth this year.

It now expects the economy to grow by 3 per cent this year, compared with its end-2001 forecast of 2.75 per cent.

"The international situation is a good deal more positive," according to Mr John Flynn, the deputy head European and international relations at the Bank.

He added that the recovery in the US economy had been relatively rapid. The European economy was also bouncing, but its recovery would lag behind the US - and would be less dramatic - reflecting the milder nature of the European downturn, he said.

Both Mr Flynn and Mr Casey were speaking at the publication of the Bank's Spring Bulletin.

Trade figures released yesterday also indicate that the economy is turning the corner. Exports in January were €8.5 billion compared with €7.9 billion in the same month last year. Imports were almost unchanged at €5 billion, producing a strong surplus for the month of €3.5 billion.

The surplus for 2001 was a record €35.3 billion compared with €27.98 billion in 2000. Medical and pharmaceuticals were the strongest sectors, with exports increasing by 69 per cent to €8.9 billion.

Exports of computers and electrical machinery also increased despite the retrenchment in the IT sector. The Bank's new growth forecast is based on "optimistic assumptions", according to Dr Casey. In order for growth to average 3 per cent for the year, the economy will have to be growing by more than 4 per cent by the final quarter of the year. This is not far off the 5 per cent growth rate which economists believe is the sustainable long-term growth rate of the economy.

The main threat to the scenario outlined yesterday by the Bank is inflation, which remains stubbornly high. The Harmonised Index of Consumers Prices used by the Bank indicated that underlying inflation rose to 4.4 per cent last year from 3.8 per cent in 2000.

This high underlying inflation meant that, "in an absolute sense, Ireland has become 10 per cent more expensive than the European average", said Dr Casey.

If inflation continues to grow in this fashion, the competitiveness of Irish exporters will be seriously undermined, reducing their ability to take advantage of the global recovery. Relatively low wages were a significant factor in the spectacular growth in the economy in the 1990s.

Inflation is currently highest in the services sector, which in turn has been driven by wage inflation in recent years, said Dr Casey.

If employees and other "economic transactors can moderate their expectations, the economy should be able to capitalise on the international recovery", he said.

Another potential threat to competitiveness flagged by the Bank yesterday was the appreciation of the euro against sterling or the dollar.

The Bank has assumed that the current favourable rates remain unchanged in its forecasts.