The primary job of a central bank is to control inflation, a task normally undertaken through adjusting the level of interest rates. The Central Bank of Ireland no longer controls interest rates - that job is now done by the European Central Bank - but it retains its traditional aversion to inflation. Its new director general, Mr John Hurley, pointed yesterday to inflation as the biggest threat facing the economy, laying particular emphasis on the need to control wage increases. Unfortunately, there appears little immediate prospect of his warning being heeded.
The Central Bank's annual report, published yesterday, traces the recent history of inflation. As the economy began to encounter capacity constraints in late 1999, the inflation rate began to pick up. Since then, Ireland's inflation rate has been 2 percentage points higher than the EU average.
To some extent, higher inflation is an inevitable consequence of our rapid rate of economic growth. Analysts have argued that higher inflation would act as a necessary brake on the economy, slowing growth to more sustainable levels. There is some validity in this argument, but the danger now is that higher inflation has become ingrained in the economy, with detrimental implications for growth in the medium term.
There are many signs of this inflationary pressure, above and beyond the official consumer price inflation figures, which show an annual rate of well over 4 per cent. One is soaring public expenditure. Another is expectations that the benchmarking process, now underway, will lead to substantial pay increases for large numbers of public servants.
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On public expenditure, the bank gently makes the point that "fiscal policy should aim to ensure a neutral stance in terms of its impact on the macro-economy." For this to happen, the new government must quickly gain control of public spending.
This will be no easy task at a time when public expectations are for improved services and continued investment in infrastructure. However, it is an issue which must immediately be tackled by Mr McCreevy, who failed to control spending over the past couple of years and must now deal with the consequences.
The Government will also quickly face the public pay issue. The benchmarking body, which is examining the appropriate level of pay for public servants, is due to report by the end of this month. It is not clear what conclusions it will reach, but it is evident that public-sector unions, and their members, expect substantial increases to result.
In many cases, higher pay levels may be deserved. However, in reacting to the report, the Government must bear in mind two issues. The first is the overall state of the public finances and the limited amount of money available. The second is the need to ensure that higher pay levels are matched by higher productivity from public servants and by a policy approach which ensures better services for the public.
The decisions which the new Government takes on these two issues - spending and public pay - could set the tone for its economic policy for much of its term in office.