Saturday 22 October 2016

Ireland's inflation rate stubbornly refuses to do what it's supposed to

Published 27/02/2014 | 02:30

THE other day, a lady of my acquaintance was trying to buy casual children's clothes with a €15 gift voucher at one of the very well-known chain stores (okay, it was Dunnes). Problem was, she could not find anything expensive enough to use up €15 without getting more T-shirts than was sensible.

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No doubt other stores could offer something similar. It is the extraordinary cheapness of most manufactured goods which is remarkable.

It certainly seems remarkable to me. Peacetime inflation was invented just as I started employment – and a household – in the 1970s. At one point, prices were rising by more than 20pc a year. That is enough to effectively wipe out the value of savings or salary in five years.

Since then, inflation has been up and down, but has always been at the centre of economic policy. A bit of inflation seemed to work better than the harsh realities of 19th-Century gold standards, provided it could be kept within bounds.

Doing that – and even deciding which bounds matter – has been the policy challenge. Looking back over those 40 years – especially from the perspective of the past five – suggests the financial authorities failed to meet the challenge.

The recent Irish experience supports one of the explanations for that failure – that no one really knows what drives consumer prices. Nor do those in charge seem very clear about the importance of consumer prices in the great scheme of things.

It always seemed a bit odd that central banks regarded the price of T-shirts as part of their key policy objective. In the end, it turned out to be tragic, rather than odd. Inflation was rampant, but it was in asset prices, rather than kids' clothes and electronic gizmos.

There is still a bit of worry about asset prices but central bankers are fixated on shop prices. For them, it is about expectations. If people think prices will keep rising, they may seek higher wages, which fuels higher prices.

If they think prices are going to fall, they will not look for lower wages, but will postpone purchases, which is bad for business. We may have seen a striking example of this theory at work in the recent behaviour of Dublin house prices.

As soon as it looked that prices had stopped falling, those with cash or access to loans appeared, not in large numbers, but displaying considerable pent-up demand.

The problem of inflationary expectations on asset prices may not have gone away but the crash has put even greater downward pressure on the prices of consumer goods – and nowhere more so than in Ireland.

The annual inflation rate last month was two-tenths of one per cent. Figures like 0.2pc do not do justice to a situation like this. It requires words. In its own way, it is as remarkable as those daily price rise of the 1970s.

Consumer prices may be an inadequate target for central banks but in Ireland's case the headline rate is inadequate, even as a guide to what is going on.

Outside factors, such as oil prices and ECB interest rates, are mainly responsible for Ireland having the lowest inflation rate in the euro area. What might be called the domestic rate of inflation appears to be running at around 3pc. Costs such as third-level education and health insurance rose by close to 5pc.

It has not escaped notice that most of these items are state-controlled or state-driven. The small firms' body ISME has made this its theme tune. Its complaints are a reminder that costs to business – and therefore to employment – can be different from costs to consumers. The inflation rate for small firms may well be higher than 0.2pc but the best figure we have – prices in the whole economy, not just households – have followed the same downward trend as consumer prices since 2008.

Many of these contributions to inflation are down to taxes and charges imposed to reduce government deficits. That is another problem with definitions: strictly speaking, new taxes are not inflation at all. They are transfers within the community and become inflationary only if they spark pass-on wage and price rises and they in turn fuel expectations about more increases.

WE have had a lot of that nonsense in the past, with pay demands based on an inflation rate which includes taxes justifiable on health grounds (drink and tobacco) or switches from tax to user charges (almost everything else).

Even in the heady days of social partnership, no consensus was ever reached on a more sensible definition of inflation and its link to pay. In the UK, bizarrely, almost everything is linked to consumer prices.

Fear that the dangerous nonsense could resume is at the centre of the recent report on prices from Forfas, the development policy body.

Its most striking feature is the inflationary pressures which appeared during the boom, quite apart from the asset price bubble.

Irish prices went from 108pc of the euro area average when the euro was launched in 1999 to 133pc in 2008. That was yet another warning sign – loudly sounded by Forfas itself – which went blithely unheeded. By those in charge.

It is equally striking how much of that loss has been recovered since 2008. The report calculates that prices are now about 112pc of the eurozone average. Much was made of the finding that Ireland is the fifth-dearest country in the zone, but the declining difference is more important than the ranking.

But for all its useful detail, there is a mystery at the heart of the report. Irish inflation has simply not behaved the way theory says it should. In a small economy so dependant on trade, most inflation changes should come from abroad, according to foreign price and currency movements.

Instead, most inflation seems to be generated, or reduced, at home. Import prices did not fall as much as would have been supposed when euro strength was increasing purchasing power.

Even more remarkably, import prices rose less than in other advanced economies since 2008, when the pressure should have been the other way.

This appears to tell us something about the behaviour of Irish businesses and a lack of price competition when business is good.

On the government side, despite all the fuss, things like education and health costs are not a large part of the typical Irish family budget. The direct taxes which pay for them are, but do not appear in the inflation figures.

It is time to reduce the role of this unreliable guide and concentrate on realities rather than indices. These include putting customers' interests ahead of those of employers and employees (ISME's included) and squeezing more value from the public sector, especially the state companies.

That would benefit national welfare: the effect on inflation should be irrelevant.

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