The biggest threat to the economy is a wage-price spiral which gets out of hand and fuels inflation, Mr Maurice O'Connell, governor of the Central Bank said yesterday.
He also warned that the gap between domestic inflation and that of the other euro zone countries was now too wide, adding that it could widen further in coming months.
In a presentation to the Oireachtas Joint Committee on European Affairs, Mr O'Connell cautioned that it was important the economy was not undermined by "wage drift". He said the Central Bank "stood by" the pay terms and tax reductions contained in the Programme for Prosperity and Fairness (PPF). These would deliver real income increases over the period of the agreement, he added.
Mr O'Connell said there was no alternative to restraint and this should apply to incomes and current expenditure generally. He said it would be easy to get into a wage price spiral which threw the Central Bank inflation forecasts of 3.75 per cent for next year "out the window".
Mr O'Connell said the gap between the domestic inflation rate and other euro zone countries had become too wide. This could be pushed higher in the months ahead by sustained services inflation, he added.
Mr O'Connell said the large budget surplus, combined with the obvious need to invest substantially in infrastructure, posed a dilemma - because this kind of expansion could cause overheating in the economy.
However, he said the Government should not pursue courses of action which pushed growth higher as this increased the danger of a hard landing for the economy.
He said there was little evidence of a slowdown in the domestic economy and there were clear signs of overheating.
Labour shortages, congestion and accelerating house prices were testament to this, he added.
Mr O'Connell said the Central Bank remained uneasy about the continuing upward spiral in property prices which generated an "inflationary mentality". He said he welcomed the Government's recent initiatives on housing but it was far too early to judge if these would work.
Inflation could worsen the impact of an external shock to the economy, such as sharp depreciation of sterling against the euro or a sharp fall in the US stock market, and would make it difficult for Irish firms to retain competitiveness, he said.
Mr O'Connell said he was concerned at the growth of consumer borrowing which was now running at 25 per cent. He said the Republic had caught up with the rest of Europe and could well end up above the European average.
"This is not where the Central Bank wants to be," he said.
However, Mr O'Connell said the whole banking system had changed utterly and there was little it could do to force banks not to lend so much.
He said the Central Bank had no powers to raise interest rates to address Irish inflation. This rested with the European Central Bank and he acknowledged current interest rates in the euro zone did not suit the Republic.
However, Mr O'Connell said the Irish economy continued to exceed expectations and was in a position that most administrations would envy. He said the euro was undervalued and should recover as the European economy improved and as familiarity with the currency increased.
There was great confidence that circulation of euro notes and coins in January 2002 would have a big influence on cementing the euro zone further, he added.
