Analysis:ESRI thinks economy weill achieve a soft landing after years of flying high, writes Paul Tansey

Having peaked in 2006, the Irish economy has now entered a phase of slower growth. The pace of economic expansion, as measured by real Gross Domestic Product (GDP), is now forecast by the Economic & Social Research Institute (ESRI) to decelerate from 6.0 per cent in 2006 to 4.9 per cent this year and 3.7 per cent in 2008.

In its Summer Quarterly Economic Commentary, published today, the ESRI anticipates that the slowdown will be of moderate proportions, implying that the economy will achieve a soft landing after years of flying high.

At a time when economic nerves are on edge, it is important to recognise the difference between slower growth and no growth. Ireland's economic world has not been turned upside down. Indeed, on the basis of these forecasts, growth in the Irish economy will continue to exceed comfortably the real expansion rate in the resurgent euro area over the next two years. Recent forecasts from the OECD indicated real GDP growth in the euro zone of 2.7 per cent in 2007 and 2.3 per cent in 2008.

In reality, as the ESRI illustrate in their forecasts, many important segments of the economy are continuing to experience boom conditions this year and will remain relatively buoyant through 2008. Thus, as can be seen from Table 1, real consumer spending - the largest component of domestic demand - is forecast to increase by 7.8 per cent in 2007 and by a further 4.5 per cent in 2008. Similarly, the Government is flashing the cash as if there were no tomorrow and the volume of its day-to-day spending is set to rise by 5.5 per cent this year. Only gross fixed investment is in the doldrums, reflecting the downturn in house building. The ESRI anticipates that housing investment will fall by 4.7 per cent this year and by a further 6.1 per cent in 2008. In cash terms, house prices are forecast to decline by 3 per cent this year before stabilising in 2008.

While the ESRI is forecasting a soft landing for the economy, it hedges its bets by identifying a series of economic risks which could cause the slowdown to be steeper - and the landing bumpier - than it is currently predicting.

The most threatening of these risks is posed by the stubbornly high rate of consumer price inflation in Ireland. Annual inflation has averaged 5 per cent in the first five months of this year, well ahead of rates in competitor countries.

But the ESRI has identified that higher prices in the shops are quickly translated into higher wages on the shop floor in Ireland. Any acceleration in wage growth in response to the current bout of inflation would further compromise competitiveness. Employment growth is already projected to weaken, from 87,000 in 2006 to just 25,000 in 2008.

Additional wage demands prompted by the rising cost of living would not only further undermine competitiveness, but would further stunt employment growth. National economic growth would stumble further as a result. The ESRI, however, is not assigning a high probability to this outcome, placing its faith in the flexibility of the labour market to contain the pace of wage growth.

In two areas, the ESRI forecast may be seen as a tad optimistic. It is projecting that average consumer price inflation will decelerate from 4.9 per cent this year to 3.0 per cent in 2008. However, this forecast is grounded on the assumption that there will be but one further increase of 25 basis points in ECB interest rates, currently 4.0 per cent. Further additions to European interest rates would send Irish inflation higher.

Second, the ESRI is projecting that the Exchequer will plunge into the red this year and next due to a steep deceleration in the growth of tax revenues. From an Exchequer surplus of €2,265 million in 2006, the ESRI is forecasting Exchequer deficits of €622 million and €1,057 million in 2007 and 2008 respectively. But in fashioning this forecast, the ESRI has accepted the official Government view that current public spending can be contained to a growth rate of 6.5 per cent next year, thus almost halving the 12.7 per cent public spending growth rate expected for 2007.

Much blood, sweat and tears will be expended by the Minister for Finance if this public spending target is to be translated into reality.