The Government’s planned budgetary package risks keeping inflation higher for longer, the Central Bank of Ireland has warned, becoming the latest institution to sound the alarm on State spending plans.
Proposed changes to income tax and spending increases above the 5 per cent spending rule, flagged by the Coalition in its recent Summer Economic Statement (SES), were likely to “amplify demand in an economy already operating at capacity”, the bank said in its latest quarterly bulletin.
“It remains important that domestic policy does not work at cross-purposes to what monetary policy is trying to achieve,” it said.
In 2021 the Government said it would not increase spending by more than 5 per cent each year. However it has moved to drop that rule amid the cost of living and housing crises.
Taxation changes
The Government has signalled a budgetary package of €6.4 billion comprising additional public spending measures of €5.2 billion and taxation changes costing an extra €1.1 billion. An additional €4 billion is also being earmarked for one-off cost-of-living measures.
Stoking demand with a big budgetary package, when the labour market is already tight, would have inflationary consequences, the financial regulator warned.
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The regulator’s warning follows similar ones from the Irish Fiscal Advisory Council and the Economic and Social Research Institute. The council in particular said earlier this month the Government risked undermining its credibility and repeating past mistakes if it breaches its own spending rules each year until 2026.
The Central Bank said recently revised national accounts data indicated the domestic economy here grew more rapidly last year than previously reported with modified domestic demand, a measure of domestic activity, 3 per cent stronger than initially estimated.
“In and of itself this is a positive development, but when placed in the context of already obvious capacity constraints, it highlights the strength of underlying demand relative to supply conditions putting upward pressure on inflation,” it said.
“The Government’s Summer Economic Statement, and the potential for additional stimulus over and above the SES parameters on budget day, indicates a procyclical shift in the fiscal stance relative to previous plans. This would amplify demand in an economy already operating at capacity, and risks leading to inflation being higher in Ireland for longer than would otherwise be the case.
“While not evident to date, if there were a more protracted period of high inflation in Ireland relative to the rest of the euro area in the future, that would ultimately prove damaging from a competitiveness perspective and reduce the scope for sustainable growth in Irish living standards,” it said.
The stronger post-pandemic recovery here would also give rise to a more gradual pace of growth in the future “as capacity constraints [particularly in the labour market] are in effect more binding” and as tighter monetary conditions weigh on demand, it said.
Post-pandemic surge
The bank downgraded its growth forecast for the domestic economy to 2.9 per cent this year and 2.6 per cent in 2024, against previous forecasts of 3.7 per cent and 2.5 per cent.
“Growth rates in the domestic economy, which were always going to ease from their post-pandemic surge, are expected to slow further as capacity constraints have become more binding,” it said. The slowdown in demand internationally resulted in a more “muted” export performance in the first half of 2023, it said.
The bank’s director of economics and statistics Robert Kelly said its report represented “a reassessment of where we are”.
The path back to more sustainable rates of inflation was also likely to be “gradual and uneven” with domestic factors, such as the price of services, playing a more prominent role, he said.
Inflation is forecast to moderate to 3.2 and 2.3 per cent in 2024 and 2025 respectively as energy, food and industrial goods price growth slows, “offsetting more persistent upward pressure on inflation from services”.
One of the main drivers of service price inflation was wages, the bank said. On the basis of the mismatch between labour demand and supply, wage growth would be 5-6 per cent this year and next. However, this was not deemed to be excessive and is currently marginally below the euro area average.
