Giveaway budget package could overheat economy, Central Bank governor warns

An overly generous budget package could potentially prolong inflation and overheat the economy, the governor of the Central Bank has warned the Government.

In his annual pre-budget letter to the Minister for Finance, Gabriel Makhlouf said there were now “binding capacity constraints” in the wider economy and labour market that were contributing “to more robust domestically-driven price inflation”.

It would therefore be “counterproductive” for domestic fiscal policy to stimulate demand, he warned, suggesting the Government should stick to its 5 per cent spending rule when it comes to funding additional expenditure or tax cuts in the budget.

“Fiscal policy has a role to play in ensuring that excessively high inflation does not become embedded in the Irish economy,” he said.

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Mr Makhlouf’s letter echoed the Central Bank’s latest quarterly bulletin, which warned the Government that big tax cuts in the budget or spending increases above the 5 per cent spending rule were likely to “add significantly” to inflation.

It comes amid rising political tensions within the Coalition over the possibility of tax cuts in the budget, and against an international background of concern over stubbornly high inflation.

Economists warn that recessions will be the price of achieving shared 2 per cent inflation goals as central banks globally enter a new phase in their battle with inflation.

[ Fragmenting global trade could trigger higher levels of inflation, warns Central Bank governor ]

Headline rates of inflation across most of the world’s economies have fallen back sharply since the autumn but core rates – which exclude volatile categories such as energy and food – remain at or close to multi-decade highs. These rates, seen as a better gauge of underlying price pressures, have sparked concern that central banks will struggle to hit their targets without wiping out growth.

“The next leg of the improvement in the inflation numbers is going to be harder,” said Carl Riccadonna, chief US economist at BNP Paribas. “It requires more pain, and that pain likely involves a recession in the back half of the year.”

With unemployment at a multi-decade low and job vacancies outstripping labour supply, Mr Makhlouf noted that wage growth in Ireland had begun to pick up reflecting “the tight labour market and a degree of real wage catch-up”. The Central Bank expects wage growth to rise above 6 per cent this year, up from 4.3 per cent in 2022.

“This underpins the expectation that while externally-driven inflation, linked to the developments in global commodity markets for energy and food, will ease substantially, the domestic factors contributing to underlying measures of inflation remain relatively high out to 2025,” he said.

“If overheating pressures become pronounced, this could result in a period of higher and more prolonged inflation in Ireland than currently expected, ultimately damaging the competitiveness of the Irish economy and potentially undermining its ability to deliver sustainable growth in living standards,” Mr Makhlouf said.

Overheating occurs when demand exceeds the productive capacity of the economy, bidding up prices and wages.

ECB interest rates

In his letter, the governor also indicated that the European Central Bank’s (ECB) current sequence of interest rate hikes was not over.

“The ECB policy rates will need to be brought to levels sufficiently restrictive to achieve a timely return of inflation to our 2 per cent medium-term target and kept at those levels for as long as is necessary,” he said.

With markets already pricing in at least one more rate hike in July, there is increased speculation that policymakers in Frankfurt may opt for another rate increase in September on the back of less favourable projections for inflation.

On corporation tax, Mr Makhlouf said saving the excess receipts to address the State’s future financial needs was “highly appropriate”. While welcoming Minister for Finance Michael McGrath’s plan to establish a new sovereign wealth fund, he said additional resources were likely to be needed to “maintain age-related services into the future”.

The cost of maintaining existing levels of public services – otherwise known as “standstill” costs – is expected to cost the State an additional €8 billion a year by the end of the decade, primarily because of increased pension costs.

“The economy and public finances have weathered significant challenges in recent years. For a combination of reasons, we find ourselves in a strong position to support both near-term macroeconomic and enhance medium-to-longer resilience in light of future challenges,” Mr Makhlouf said.

“In doing so, choices should be made to protect against overheating dynamics, ensure against excessively high inflation does not become embedded to the detriment of households and businesses, and promote sustainable growth in living standards,” he said. – Additional reporting The Financial Times Limited 2023