For any central banker, one of the privileges in life is the ability to be able to respond to a perceived or real inflation threat through the use of the time-honoured interest-rate tool. This has been demonstrated very clearly in the US in recent days, with the Federal Reserve increasing interest rates by a half of 1 per cent, just hours after the release of a very tame inflation report.
Mr Alan Greenspan, chairman of the Federal Reserve, obviously believes that there is a real inflation threat lurking in the undergrowth and he has the luxury of responding accordingly. Not so for the governor of Ireland's Central Bank, Mr Maurice O'Connell, who has seen inflation increase four-fold since last July and yet is not in a position to do anything about it.
Then again why should Mr O'Connell worry about it? Ireland's inflation situation is after all a problem for Mr Wim Duisenberg, president of the European Central Bank, but even he is unlikely to be losing too much sleep.
That is little consolation for domestic business and consumers who are seeing a significant deterioration in their cost environment.
In explaining its move in rates this week, the Federal Reserve pointed to the fact that demand was continuing to exceed potential supply, despite the remarkable productivity performance of the economy. It is feared that this imbalance will continue and could ultimately result in an inflationary environment that would undermine the superb economic performance of recent years.
No specific mention was made of labour-market conditions, but the underlying concern for the Fed is the labour market. The unemployment rate currently stands at just 3.9 per cent and, despite annual net immigration of around one million people, most employers are reporting difficulties in recruiting workers.
A walk through any US city at the moment will demonstrate this very clearly, with "help wanted" signs in many windows.
This all sounds very familiar to observers of the Irish situation. The economy is booming, demand is most definitely outpacing supply, the economy is operating very close to full employment and employers are finding it increasingly difficult to retain and recruit staff.
The biggest difference between the US and Ireland, is that inflation in the former is running at just 3 per cent, compared to 4.9 per cent in Ireland. Despite this, base interest rates are now 6.5 per cent in the US and just 3.75 per cent in Ireland.
Clearly there is something not quite right about this whole cocktail.
The reality is that the Irish economy has received a very strong boost over the past couple of years from the interest-rate environment that EMU has delivered. Demand has rocketed while supply is failing to keep up, not least because of the constraint imposed by the limited supply of labour.
Despite the assertion by some that economic textbooks should be ignored in Ireland's case, what we are currently experiencing on the price front is a classic response to an imbalance between demand and supply. The big question of course is whether we should be worried about this situation, and if we should what can we do about it.
The answer to the first question is yes to a limited extent, and the answer to the second is nothing, at least in the short term.
April's inflation report could be described as bordering on the disturbing. The deterioration on the cost front since last July has been quite dramatic. Granted we can attribute much of the deterioration to factors outside our control such as oil prices, rising eurozone interest rates and the dismal performance of the euro, but the underlying picture is also poor. Some will argue that if we strip out tobacco, mortgage rates and oil prices, the underlying picture is not quite so bad.
However, if we strip out everything there would be no inflation. The reality is that the headline rate of inflation is what matters to economic agents and what drives wage and future price expectations.
By far the most worrying aspect is the 6.5 per cent rate in the services sector. This is the most visible manifestation of the labour shortages in the economy and looks set perhaps to climb as high as 10 per cent over the coming months.
The economic reality for a small entity like Ireland in a larger economic region is that if it inflates at a significantly higher pace than the rest of the region with which it trades, relative competitiveness will suffer and ultimately growth will slow and jobs will be lost. The experience of the US in areas such as Washington and New England would bear this out.
This is fine in theory but, in practice, certain sectors will be hit hardest. In Ireland, one can identify agriculture and labour-intensive manufacturing as the most vulnerable.
However, from an overall macro-economic point of view, relatively high inflation could act as a safety valve and take the economy down to a more sustainable growth plane. The risk of course is that current inflation levels start to get built into the psychology resulting in the development of a wage-price spiral, ultimately leading to a harder landing for the economy.
Interest rates would be most effective in tackling the problem, but that tool is not available. Suggestions have been made that indirect taxes should be cut, but this would only result in another boost to consumer demand and at most a temporary reprieve on the inflation front.
There is no short-term solution. Longer term we need increasingly to deregulate the economy, accelerate the privatisation process and facilitate an increased supply of labour. All very noble aspirations, but difficult to deliver.
In the meantime competitiveness will be further eroded, but it is better to have that happening at current unemployment levels rather than those of a few years back. We have to be sanguine about the situation, simply because we have no choice.
Jim Power is chief economist at Bank of Ireland Treasury. The views expressed here are personal.
