KEEPING THE INFLATION GENIE IN THE BOTTLE

Dermot O’Leary Chief Economist Goodbody Stockbrokers

As businesses and consumers know, price pressures are rising in the domestic economy. Has the enemy of inflation returned asks Dermot O’Leary.

When evidence emerged in the summer that inflation risks were increasing in the US economy, the financial markets got a serious bout of the jitters as it meant that interest rates may rise further. More recently, inflation matters have been gaining significant attention here at home.

INCREASED FUEL COSTS

There is no doubt that the latest evidence is slightly concerning. Not long after learning that inflation reached a new three year high of 4.5% in August, the energy regulator revealed that not only would householders and businesses have to deal with a 34% increase in gas prices in October, but they would have to stump up another 20% for their electricity from January. As a result, the odds of inflation topping 5% by the end of the year have shortened significantly.

High inflation rates are not a new phenomenon in Ireland. In November 2000, inflation reached the 7% mark, which was the highest rate in recent times. That period was primarily responsible for Ireland becoming the most expensive country in the euro zone, but now price rises are accelerating even off that high base.

HIGH INFLATION

Worryingly, inflation rates in Ireland are starting to diverge with the rest of Europe, for the first time in over two years. Using the HICP measure (the Europe-wide measure of inflation), prices increased by 3.2% over the past twelve months. In Europe as a whole, prices increased by only 2.3% over the same period.

While the Irish economy continues to flourish, and the prospects continue to be bright in the short term, these types of issues do provide early warning signals for the future of the economy into the medium term. Ireland has built much of its success over the past two decades around the ethos of taking advantage of an evergrowing international marketplace. However, to be able to do business in this marketplace, firms must be able to compete on all counts. Costs are obviously a big factor in this.

CUTTING COSTS

With input costs rising faster here than the rest of Europe, the playing field is becoming increasingly uneven. For businesses to maintain market share internationally, they will have to cut costs in other areas or increase productivity levels. This, however, is not a strategy that can be used indefinitely. Inflation can also affect the way in which an economy operates. By eating into real disposable income, higher inflation can have a profound effect on the most important component of expenditure in the Irish economy, namely consumption growth.

Furthermore, beyond the direct effect on real spending, inflation scares can also have an effect on confidence, which in turn leads to consumers postponing spending even more. In this regard, some of this month’s fall in consumer sentiment can be put down to rising inflationary concerns.