Rising house prices could be an indicator of even higher inflation to come, bringing an erosion of our competitiveness, a Central Bank paper has warned. The paper, written by Central Bank economist Mr Geoff Kenny, also cautions that the banking sector could be exposed to any downturn in the housing market and that managers in charge of lending may not be careful enough about risk, as they are given incentives to maximise the amount they loan out.

According to Mr Kenny it is "a common finding that financial institutions do not adopt a prudential approach to lending until it is too late."

The paper, written earlier this year, also points to the dangers of escalating pay demands due to rising house prices. However, the Bank points out that the views expressed in it are not necessarily its own and are the responsibility of the author.

In the technical paper Mr Kenny points out that a period of high real interest rates may be needed to force inflation out of the economy, but of course, this is ruled out by monetary union.

He also points out that a fall in income tax payments would raise the demand for housing.

According to Mr Kenny the price paid by a new homebuyer in Ireland rose by 42 per cent since the start of 1994 compared with a total increase in inflation of only 5.6 per cent. And in many industrial countries, sharp increases in house prices have often been blamed for subsequent periods of high and volatile inflation.

Many economists have argued that because Ireland is such a small open economy the exchange rate of the pound is the crucial factor in determining inflation. But according to Mr Kenny, there are good reasons why this should not be used to dismiss the notion of house prices feeding into inflation.

He points out that rising house prices can feed into higher expectations of inflation and could have a "lasting effect" on Irish inflation, hitting our competitive position.

The report finds that house prices gave a good indication of inflation for most of the time from 1975, except the years from 1988 to 1990 and 1994 to 1997.

Another reason, according to Mr Kenny, to expect high inflation to result from rising house prices is because people expect prices to increase more generally and because rising prices can lead to demands for higher wages and also feed through to consumer demand.