Inflation is being shaped more by domestic factors
DOMESTIC conditions – especially recessions – have a bigger effect on Irish inflation than has been generally assumed by economists, new research from the Central Bank has found.
The research was sparked by the sharp deflation after the 2008 crash, when Irish consumer prices fell 5.5pc in the following two years. This was all the more surprising given that prices in Britain rose by up to 5pc.
"Many economists have argued that Irish inflation is primarily determined by external factors, such as the exchange rate, oil prices and import prices, with little role given to domestic factors," the report said.
"The deflation experienced during the crisis is very unusual by domestic historical standards, and also relative to the experiences of other countries during the so-called 'Great Recession'," it said.
The period of deflation was also unusually long. Inflation resumed in other countries quickly, but Ireland remained in deflation for 22 months.
The study found that the relationship between economic conditions and inflation is not stable but seems to depend on the state of the business cycle, with domestic factors such as unemployment having a greater influence during recessions.
The theoretical models constructed by the researchers predicted the actual fall in prices during the financial crisis quite accurately.
"These results provide support for the idea that inflation is not purely externally determined in Ireland. There is a role for the domestic economy to play in terms of understanding inflation, particularly during recessions," they say.
Another piece of Central Bank research found that large budget deficits and high interest payments on foreign debt represent key 'tipping points' for countries which default on their debts.
Other studies have found that credit-rating agencies attach little weight to these kind of indicators "despite their reliability as leading indicators of both currency crises and default", the report said.