The Economic and Social Research Institute(ESRI) has raised some important points in its latest commentary on the economy. It identifies the difficulties facing the Government and the Central Bank in managing the currency markets and also the threat posed by the sharp rise in prices in parts of the housing market. However it is far from clear what action the Government can take to address these issues.
The root of the problem facing Irish policy makers is that we are heading towards monetary union at a time when economic growth here is much faster than anywhere else in Europe. To compound the resulting difficulties, the currency of our main trading partner is rising rapidly. Normally a rise in interest rates is the weapon that the Central Bank would use to control inflation. But because rates must fall to the level of our EU partners by the time monetary union starts in January 1999, the Bank will not be able to increase borrowing costs in the months ahead. If it did so, then a potentially destabilising sharp fall in interest rates might take place next year. The strength of the pound in the ERM band also precludes higher interest rates, as a rise in rates might push the Irish currency even higher in the ERM band.
So Irish policy makers are severely constrained in their efforts to calm the housing market. Fortunately, to date there is little or no evidence of a rise in the general rate of inflation. However, the ESRI says that the Government should still consider some specific measures such as tighter regulation of lending conditions, or even a special tax on consumer borrowing.
The ESRI makes some sound recommendations on overall policy direction. It correctly points to the need for tighter management of public spending and says it is essential that long term economic health takes precedence over "perceived sectoral grievances." It also points to the need to tackle Ireland's social problems within the tight fiscal constraints which need to apply in the run up to monetary union.
However, it is difficult to prescribe solutions to the problems of controlling inflation and managing the currency. Higher interest rates are clearly not an option. And beyond ensuring that the lending institutions stick to prudent guidelines, it is not easy to come up with measures to dampen the housing market. A fall in the value of sterling would ease the difficulties facing the Government and the Central Bank. This would help lower the pound's value in the ERM, lower the price of sterling imports and greatly ease the transition to monetary union. As the ESRI points out, the currency markets are notoriously unpredictable and the Government and the Central Bank cannot rely on sterling moving onto a downward track. Ireland is certainly on course to qualify for monetary union, but the run up may still be a difficult one, as an additional question - the precise rate at which the pound would be valued, comes more and more into focus.