The Central Bank has little chance of persuading workers to ignore the high 'headline' inflation rate while mortgages are costing more, writes Paul Tansey.
Inflation hasn't gone away you know. The Central Bank, in its 2006 annual report published yesterday, predicted that consumer price inflation would average 5 per cent this year. Moreover, inflation, as measured by the Consumer Price Index (CPI), is projected to remain relatively high in 2008. The Bank has recently revised upwards its forecast for CPI inflation next year from 3.5 per cent to 3.75 per cent.
At the time of the 2007 Budget, the Department of Finance was forecasting CPI inflation at 4.1 per cent this year and 2.4 per cent in 2008. The acceleration in CPI inflation in the interim is due to two principal factors: rising interest and mortgage rates; and increasing energy costs, particularly climbing oil prices.
The bank's inflation projection for 2008 is significantly higher than the 3 per cent increase in average consumer prices forecast only last week by the Economic & Social Research Institute (ESRI).
Clearly, inflation matters to consumers because it confiscates purchasing power. But it also matters to the economy's overall health because of its impact on national price and cost competitiveness. Even within the euro zone, where Irish prices are rising faster than prices in competitor countries, markets will be lost, profits depressed and jobs threatened, other things being equal.
Outside the single currency regime, the adverse effect of excessive Irish inflation on competitiveness can be exacerbated by the behaviour of exchange rates. Thus, the US dollar's recent decline from an average exchange rate of $1.26 against the euro during 2006 to $1.376 yesterday tightens the competitive screw on Irish firms seeking to export to the United States. And the United States remains Ireland's biggest single market abroad.
Excessive inflation undermines price and cost competitiveness in three principal ways. First, it raises the general costs of doing business in Ireland relative to costs in competitor economies. Second, it raises inflationary expectations. If average prices are rising now, people expect them to rise in the future and make their plans accordingly. Third, and most importantly in current circumstances, the current rate of inflation in Ireland quickly feeds through into higher wages, as workers seek compensation for rising prices.
An exercise recently conducted by the ESRI found that 50 per cent of the increase in the Consumer Price Index in one quarter is reflected in wage increases within three months. On this basis, the ESRI forecast average pay rises of 5.5 per cent this year followed by 5 per cent in 2008, excluding any additional awards made by the Public Sector Benchmarking Body.
The extent to which earnings growth is compromising competitiveness can be gauged by comparing pay increases in Ireland with wage growth in competitor economies. In 2006, average Irish earnings advanced by 4.6 per cent compared with average increases of just 2.6 per cent throughout the euro zone and average pay rises of 1 per cent in the renascent German economy.
Moreover, in recent years, Ireland has not managed to compensate for its relatively higher wage growth by outperforming trade rivals in the productivity stakes. Relative to the 1990s, Ireland's productivity growth - annual increases in real value-added per worker - has been quite poor.
On the other side of the coin, higher inflation is doing workers no favours. The current national pay agreement provides for cumulative basic increases of 10.4 per cent over a 27-month period, equivalent to compound annualised increases of 4.5 per cent.
However, virtually all of these basic pay increases will be swallowed up by rising prices. On the basis of the Central Bank's inflation forecasts for 2007 and 2008, the average level of prices in the two years will increase by 8.9 per cent. This leaves employees looking either to budgetary tax cuts or to additional pay claims to achieve any appreciable gain in their real living standards over the currency of the agreement.
The Central Bank, along with most economists, does not favour the use of the Consumer Price Index as a measure of inflation. Their preferred inflation indicator is the Harmonised Index of Consumer Prices (HICP), calculated on a common basis throughout the euro zone.
The major difference between the two measures of inflation lies in the fact that the HICP excludes mortgage interest. Since mortgage interest rates have been propelled upwards by successive increases in European Central Bank interest rates - they have jumped from 2 per cent in December 2005 to 4 per cent today - the CPI measure of inflation is much higher than its HICP counterpart.
The Central Bank is forecasting that Irish inflation, on an HICP basis, will decelerate from an average rate of 2.75 per cent in 2007 to about 2.25 per cent next year. At a briefing yesterday, Central Bank Governor John Hurley said that it would be "completely counterproductive" for employees to seek wage increases to compensate for increases in interest rates that had been introduced in order to curb inflation.
In other words, when formulating wage claims, employees should avert their eyes from the high "headline" rate of inflation portrayed in the Consumer Price Index and focus instead on the lower inflation numbers contained in the HICP.
While the Governor is economically and technically correct, the chances of achieving this outcome are slim. Many years ago, the government sought to introduce a constant tax price index which stripped out the effects of price rises due to budgetary tax increases.
It was hoped that this tax-free price index would form the basis of subsequent pay negotiations. Unsurprisingly, it never caught on.