The Central Bank has warned that if Government expenditure in next year’s Budget goes beyond its 5% spending rule, it runs the risk of stoking inflation further.
In its Summer Quarterly Bulletin, the Bank has also revised upwards both its forecasts for growth in the domestic economy and also for inflation.
The economy is described by the Central Bank as operating “at capacity” and “effectively at full employment” with “risks of overheating”.
It says with energy and food commodity prices falling, the main driver of inflation now will be domestic factors linked to higher wages, higher profits from companies that can push up prices and higher demand from consumers.
The Central Bank says with the economy running at capacity, pumping more money through higher spending or tax cuts on a similar scale as last year will add to inflation.
It goes further to warn that sticking to the government’s 5% spending rule also risks making some of the imbalances in the economy worse.
The Central Bank also estimates that if it were not for the series of interest rate rises over the past year, inflation in the economy might be two to 2.5% higher.
It expects underlying inflation, which excludes energy and food prices, to peak at the end of this year and to average at 4.9% for the year.
That is an upward revision on its Spring forecast of 1.4%.
The bank expects headline inflation to average out at 5.3% this year before slowing to 3.4% next year and 2.5% in 2025.
It expects the domestic economy to grow by 3.7% this year, as measured by Modified Domestic Demand, and by 2.5% next year.
It says recent swings in quarterly GDP growth illustrate how much that measure is determined by the activities of multinationals and does not paint a reliable picture of what is happening in the economy.
The Central Bank expects nominal wages to grow by around 6% this year and next and expects real wages, which take account of inflation, to recover and end up higher than 2021 levels by the end of 2024.
Adhere to the rules
Robert Kelly, Director of Economics and Statistics at the Central Bank said the regulator was expecting growth to improve in the near term and for slightly stronger consumption over the next twelve months.
However, with the rate of inflation across the economy still well above the Central Bank’s 2% target, he said it was important that the government sticks to its spending rules.
“There is a need for domestic policy to contribute to near term macroeconomic stability and not work at cross purposes with monetary policy. This is best achieved by adhering to the 5% spending rule,” he told Morning Ireland.
“If we become delinked from what’s happening in the euro area, it will damage Ireland’s competitiveness if inflation remains higher here relative to the euro area. There are real dangers in terms of our standards of living if that is allowed to persist,” he said.
Mr Kelly said there were well-documented risks in allowing excess corporate tax receipts to feed into current spending.
However, he said they did provide opportunities to build capacity to the medium term challenges, such as climate and ageing.
“While Ireland is good in a relative sense in Europe, the picture will change rapidly. Department of Finance estimates show that we will need to spend €7 to 8 billion more to fund the same level of services for an ageing population.
“We could start to save excess corporate tax receipts into a fund this year and in coming years and it would reduce – maybe not eradicate – the need for further tax increases by 2030, but it will certainly help the transition where we will have a larger older population requiring more spending,” he explained.
On the recent figures showing a slight increase in short-term mortgage arrears, Mr Kelly said it was too early to interpret it as evidence of a developing surge in arrears.
He pointed out that some of the recent increase arose as a result of reclassification of short-term arrears.
“It’s the labour market we’re watching closely. If we see unemployment starting to rise, that’s the key determinant of whether we’ve something more systemic in terms of arrears,” he said.