The current Irish inflation rate of 5.5 per cent exceeds the unemployment rate of 4.5 per cent for the first time since 1982. While noteworthy, this occurrence has no particular significance in itself, though the Economist magazine often constructs what its calls a misery index that adds these two rates together. The higher the combined value, the more miserable is the economic situation.
Ireland's misery index, having been on steadily declining trend for more than 15 years, has risen in recent months as inflation rates have ratcheted upwards while the unemployment rate has declined more moderately. A reading of 10 on the misery index is about average for other euro zone member-states with their relatively high unemployment rates, but only a third of the levels experienced in the early 1980s with inflation and unemployment both making fairly equal contributions. The main Irish economic concern, however, has firmly shifted to inflation as the economy approaches full employment.
The sharp rise in consumer prices, as measured by the Consumer Price Index (CPI), has been interpreted as evidence of overheating in the Irish economy and seen as eroding the wage increases agreed under the Programme for Prosperity and Fairness (PPF).
Action to address these outcomes has been called for. The problem is how to do so in mutually compatible way. An overheating economy results from a mismatch of demand outstripping supply. Measures aimed at increasing the economy's supply capacity are inherently medium term solutions so the short-term problem is to identify ways to moderate demand while maintaining real value of income rises.
As a small open economy within a large monetary union, the inflationary process in Ireland is significantly, though not exclusively, determined by external factors. A substantial part of the recent rise in CPI inflation has nothing to do with overheating in the domestic economy but reflects "imported inflation" arising from external factors, such as weakness in the euro and the rise in the international price of oil. The CPI is also influenced by domestically determined price changes.
Overheating in the economy is evident in the growth of domestically generated inflation through high wage increases reflecting tightness in the labour market. Other domestically determined price changes do not necessarily reflect demand conditions in the economy. These include administered price changes, such as the 50 pence rise in tobacco duties in the last Budget, and modifications to indirect tax rates, such as those proposed to reduce the CPI to protect workers' real wage increases under the PPF.
Reductions in indirect taxes do little to directly influence the main determinants of inflation but they can adjust the CPI measure of inflation. Changes in the CPI can influence expectations about general price movements and real incomes, and so potentially affect demand factors through moderating wage pressures. Manoeuvring the CPI measure downwards by indirect tax cuts is a one-off move and by raising the purchasing power of workers it is likely to increase rather than moderate demand. While there may well be merit in changes to general indirect tax rates as part of wider tax reforms, manipulating an index measure of inflation does not constitute grounds for pursuing this strategy.
The principle of moving to trading wage moderation for indirect tax reductions would be a new departure in the social partnership arrangement away from the convention of using income tax cuts to boost disposable incomes. It may not be prudent to undertake such a departure in reaction to what might yet prove to be a temporary phase of inflationary pressures. A more fundamental concern is that the proposals appear consistent with a strategy of confronting inflation by learning to live with it through indexing real incomes to account for price level changes.
The type of indexation proposed is somewhat unusual by attempting to fix the index itself rather than adjusting nominal wages. Either way it does not confront the main source of domestically generated inflation, which is excess demand. The experience in the 1970s internationally of indexing arrangements is that such income proofing, while reducing the costs associated with a given level of inflation, pushes inflation rates higher through changed expectations about the costs associated with rising prices.
There is justifiable concern that actions be taken to protect real wages by bringing inflation under control, but indexing, in whatever form, is unlikely to be the best way to proceed. The danger with manipulating the CPI is that it would raise the expectation that the Government would continually attempt to negate the impact of price rises on real wages. This could create a moral hazard, whereby groups are provided with an incentive to incur costs that they do not have to bear. Indexation of wages to price rises would introduce unwarranted rigidities when what is needed is flexibility. The necessary flexibility could be provided under more imaginative use of broader economy wide gain-sharing arrangements than are currently envisaged under the PPF.
Danny McCoy is an economist and editor of the Quarterly Economic Commentary at the Economic and Social Research Institute.
