The intersection of energy price spikes with a post-pandemic rebound in demand running up against supply constraints has resulted in the highest inflation rates in Ireland for nearly half a century. The impact has been to reduce household income in inflation-adjusted terms and, in doing so, to dampen consumer spending.
What initially appeared to be a narrow-based increase in prices, driven by a post-pandemic imbalance between demand and supply, has become an increasingly broad-based phenomenon. Higher input costs for almost all sectors of the economy have triggered second-round effects, as firms pass on higher costs to consumers in order to maintain profit margins; ‘core’ inflation, which excludes energy prices, has accelerated sharply. This external inflationary impulse is being aggravated by the imbalance between demand and supply in parts of the labour market, which has pushed up wages.
Energy price inflation intensified over the summer, as concerns regarding a complete shut-down of Russian supply to continental Europe triggered a ‘dash-for-gas’. The wholesale price of natural gas in early September traded at around eight times its norm. As a result, consumer price inflation in advanced economies is running at its highest rate in nearly half a century. In response, central banks in almost all advanced economies – including in the euro area – have frontloaded monetary policy normalisation, an additional economic headwind.
In a nutshell, therefore, the economic silver linings in Ireland’s key export markets are few and far between.
The Irish experience mirrors that elsewhere and, against this very difficult backdrop, the short-term outlook for the Irish economy has changed markedly since the spring. The third quarter looks like a turning point, with several high-frequency indicators moving into negative territory.
Modified domestic demand (MDD) growth of 7.7 per cent is now expected for this year; much of this growth is a ‘carry-over’ from the strong bounce-back seen in the second quarter, following the end of the pandemic. For next year, MDD growth of just 1.2 per cent is assumed, a downward revision of 2.7 percentage points relative to the department’s spring projections.
Employment reached an all-time high in the second quarter of this year, helped in part by the various supports put in place by the government during the pandemic. In keeping with the outlook for demand, however, employment growth is expected to slow in the near-term; that said, the unemployment rate is expected to remain at relatively low levels throughout the forecast horizon.
On the prices side, an average inflation rate of 8.5 per cent is in prospect for this year, with the rate peaking at 10.4 per cent in the fourth quarter. This would be the highest rate since the HICP series began in 1997. For next year, inflation of just over 7 per cent is projected, reflecting the ‘higher-for-longer’ assumption for gas prices.
Economic activity rebounded in the second quarter of this year (figure 1A), as mobility restrictions, in place during the opening months of the year to limit person-to-person transmission of the Omicron variant were lifted. As expected, the ending of the pandemic boosted consumer spending and triggered a rapid rebound in employment. At the same time, private sector investment in plants by parts of the multinational sector, as well as spending on machinery and office equipment to facilitate remote-working, led to very high investment rates.
Price pressures had been building up from the second half of last year (figure 1B), reflecting rising geopolitical tensions and pandemic-related supply-chain problems. These price pressures intensified following the outbreak of war in Ukraine, which triggered very large price increases for many commodity prices, especially fossil fuels. As a result, consumer price inflation is now running at its highest rate since the 1980s, a situation mirrored elsewhere. As Ireland is a net importer of energy products, higher prices mean a transfer of purchasing power abroad.
This shock to real incomes is taking its toll on the economy, and is the main channel through which the war in Ukraine is impacting domestically. Monetary policy has tightened, external demand is weakening and uncertainty remains elevated. These factors will likely act as a brake on investment.
Against these mounting headwinds, real-time and forward-looking indicators point to a reduction in economic activity over the remainder of the year and the early part of next. Higher price inflation is eroding real incomes, though government measures – including those announced in Budget 2023 – will provide some support to households, firms and domestic demand.
Figure 1
Consumer spending is the largest component of MDD and, as such, a key driver of overall developments. Despite the very strong recovery in employment since the mid-part of last year, as well as the accumulation of around €18 billion of ‘excess’ household savings built up during the pandemic, the evidence suggests that the rebound in consumer spending post-pandemic has been somewhat weaker than initially assumed. This mostly reflects the energy-induced price squeeze, with higher-than-anticipated inflation eroding household disposable income. It may also reflect households prioritising savings over spending, with greater risk aversion stemming from the outbreak of war on the European Union’s border.
Following the full relaxation of pandemic-related restrictions, consumer spending recovered in the second quarter, increasing by 1.8 per cent relative to the previous quarter, and resulting from the rotation of spending from goods towards contact-intensive services. Notwithstanding this rebound, real consumer spending levels remain marginally below the pre-pandemic level, although nominal spending is 10 per cent higher than immediately before the pandemic.
Higher frequency data (figure 2A) – such as retail sales and card payments data – suggest a weakening of consumer goods purchases from around April / May, a trend which has continued into the third quarter. The department’s ‘nowcast’ model suggests a quarterly decline in consumer spending (and MDD) in the third quarter (figure 2B). The decline in purchasing power associated with higher winter fuel bills is assumed to continue to weigh on consumer spending in the final quarter.
On this basis, consumer spending is expected to expand by 5.5 per cent this year, with much of this coming from a ‘carryover-effect’ from the post-lockdown bounce-back last year. Indeed, comparing the expected level of spending at the end of this year with that in the fourth quarter last year – thereby stripping these ‘carryover’ effects – shows a much more modest increase of just 0.7 per cent.
Following the stop-start nature of construction activity during the pandemic, new house building picked-up strongly over the past year, with an annualised level of commencements of nearly 30,000 units in the second quarter of this year; the equivalent level of completions was 25,000 units in the same period. However, with mounting headwinds – in the form of higher input costs and shortages of labour – momentum in the house building market appears to be slowing.
Beyond the housing market, business spending more generally has remained robust, driven by strong investment in ‘core’ machinery and equipment. This appears to reflect the continued expansion by the multinational sector of its Irish operations, as well as broad-based investment in office and computer equipment by businesses, including to accommodate ‘hybrid’ working. That said, the pace of investment spending is expected to slow as inflationary pressures become more pronounced, financing conditions tighten and the global economic outlook becomes increasingly uncertain. Against this unfavourable backdrop, businesses are expected to delay or even postpone large investment outlays.
Bringing all of this together, MDD is expected to grow by 7.7 per cent this year. This is an upward revision relative to the spring forecasts of over 3.4 percentage points, mainly driven by a small number of large investments by the multinational sector, the increase in public expenditure due to the arrival of Ukrainian migrants, and the various cost-of-living supports introduced by Government.
Parts of the multinational sector continue to perform very strongly, notably the pharmaceutical, med-tech and information and communication technology (ICT) sectors. In the first half of the year, the volume of goods exports originating in Ireland increased by a quarter over the same period last year (figure 3A). Services exports remained strong, led by ICT exports, with Ireland now one of the major exporters globally in this sector. As a result, the foreign-owned sector contributed around 8 percentage points to the growth of gross value added in the first half of the year in annual terms, compared with 4 percentage points in the domestic sector (figure 3B).
Figure 2
While much of the profit arising from these activities is repatriated to non-resident shareholders, a significant slice remains in the domestic economy, in the form of corporate tax receipts, wages and income taxes. Indeed, total wages in the foreign-dominated manufacturing and ICT sectors grew at an annual rate of 15 per cent in the first half of the year, with a combined pay-bill of around €13.8 billion in these sectors over the same period. Indigenous exports also recorded relatively strong growth, with food exports up by a fifth (in value terms) in the first half of the year.
Figure 3
Overall, exports are projected to grow by 12.5 per cent this year, with imports expected to grow by just over 7 per cent. The net effect would result in GDP growth of 10 per cent (GNI* of 5 per cent) this year.
The government’s economic policies during the pandemic have yielded a positive return in the labour market. By the second quarter this year, during which the Pandemic Unemployment Payment and Employment Wage Subsidy Scheme were fully phased out, the level of employment stood at over 2.55 million, an all-time high. Much of the additional labour has come from increased participation rates, particularly by females and younger workers. The entry of Ukrainian migrants under the Temporary Protection Directive has also had a positive impact on labour supply, with almost 8,500 of those arrived now in employment. Overall, the labour market remains exceptionally tight, with the unemployment rate at 4.3 per cent in August.
In the face of moderating demand, employment growth is expected to soften in the third quarter, and ultimately dip in the fourth quarter. A modest up-tick in unemployment is anticipated, with the unemployment rate projected at just under 5 per cent at year-end.
Economic prospects in Ireland’s main export markets have weakened, as real incomes fall on foot of higher inflation. A front-loading of monetary policy normalisation, tighter financial conditions and heightened geopolitical tensions – including, but not limited to, those related to the Russian invasion of Ukraine – are additional headwinds that will likely tip some of Ireland’s key export markets into recession.
Table 3
The weaponisation of Russian gas supplies means that Europe is the epicentre of the global energy shock. Activity in the euro area has softened and is projected to move into negative territory in the second half of the year, as the squeeze on real incomes takes its toll. For next year, activity is projected to increase by just 0.3 per cent (table 3). In the UK, the energy shock is being aggravated by the additional supply-side shock associated with exiting the European Union, although the September fiscal measures (e.g. energy ‘price cap’) may, temporarily, limit the scale of the slowdown. While the US economy is less exposed to the energy price shock, the aggressive pace of monetary tightening is weighing on activity, especially in residential investment. In China, the unravelling of the property bubble continues to depress activity, with potential spill-overs to other parts of the world.
Box 1
Figure 4
Against the backdrop of a broadening of price pressures and persistently higher inflation, the stance of monetary policy across all advanced economies is shifting. Policy rates are being increased alongside a scaling-back of quantitative easing. The objective is to prevent inflation becoming entrenched, an outcome that would require an even more aggressive policy response at a later date. In some regions, central banks have gone a step further, announcing ‘quantitative tightening’ (reduction in the size of central bank balance sheets) in the coming months. Taken together these measures are intended to curtail price pressures albeit at the cost of lower levels of aggregate demand in the months and quarters ahead. A key risk is that inflation becomes more persistent and inflationary expectations become de-anchored; this could require an even more aggressive monetary policy response in the relevant jurisdictions. On a more positive note, there is some evidence that global supply chain difficulties are beginning to unwind (Box 1).
Differences in the stance of monetary policy are a key factor behind recent exchange rate re-alignments. The stand-out development has been the appreciation of the US dollar against a range of currencies, with ‘safe haven’ flows possibly an additional explanatory factor (Box 2). By raising the domestic cost of servicing dollar-denominated debt, dollar appreciation is the source of considerable market distress in several Emerging Market Economies (including some in Europe).
From an Irish perspective, the euro-dollar bilateral rate breached parity in mid-August, the first time since 2002 and this will add to inflation (by raising the euro price of oil, for instance). In terms of constructing the department’s economic projections, the rate averaged around €1 = $1 in the first half of September and, on the basis of the purely technical assumption of no further change over the remainder of the forecast horizon, this would imply a euro-dollar depreciation of around 11 per cent this year and 5 per cent next year (figure 5A). The euro-sterling rate has been more stable; a similar, purely technical approach of no further change would imply a euro-sterling depreciation of around 1 per cent this year and appreciation of 1 per cent next year (figure 5B).
Figure 5
The prospect of a near-cessation of Russian natural gas exports triggered a further jump in wholesale gas prices over the summer, as many EU countries scrambled to secure gas supplies. Prices in the first half of September traded at around stg£4.20 per therm, over 3 times higher than this time last year (figure 6A). Because prices at this level will likely usher in a recession in many jurisdictions, wholesale prices for oil (and some other commodities) have fallen, given the likelihood of lower demand (figure 6B). That said, prices remain materially higher than this time a year ago, especially in the euro area where the depreciation of the euro-dollar bilateral exchange rate have pushed up domestic prices.
Figure 6
On the basis of futures markets in mid-September, oil prices are expected to average around $101 (€96) per barrel this year, and around $89 (€89) per barrel next year. UK gas futures currently stand at stg£6.10 per therm on average over the winter (final quarter of this year, first quarter of next year) and stg£5.50 per therm on average for next year (the long-run average cost per therm which held to the middle of 2021 was around 50 pence).
The department’s macroeconomic projections for next year are conditioned on the assumption of no major economic disruption arising from the reduction in Russian gas supplies to continental Europe. In other words, while there may be a cessation of Russian natural gas supplies, it is assumed that alternative energy sources and demand-management measures can plug most (though maybe not all) of the gap in larger continental countries. On this basis, the sharp jump in prices remains the main channel through which war in Ukraine is impacting on the domestic economy (an alternative more disruptive scenario is detailed in chapter 6).
The key determinants of the outlook for the domestic economy next year are the decline in domestic purchasing power and the deterioration in the external environment. While wages will offset some of the increase in the price level, real income growth is expected to be negative again next year, and this will act as a drag on consumer spending. Similar dynamics are at work in Ireland’s key export markets and so the external outlook is much weaker than assumed in the department’s spring forecasts.
The inflation rate is expected to ease only gradually next year and this will continue to erode household purchasing power. In real terms, household disposable income is projected to decline next year. While some households may choose to tap into their savings – including the windfall savings that accumulated during the pandemic – to support spending, this option is not available to all households. Moreover, heightened uncertainty and weak consumer sentiment mean that some households will place a premium on accumulating savings rather than spending.
Against this general backdrop, real consumer spending growth of 1.8 per cent is projected for next year, with nominal growth significantly higher at just over 8 per cent in the face of ongoing inflationary pressures. This projection assumes that real spending moves sideways in the first quarter of the year, before picking-up moderately thereafter (figure 7A).
Two factors will influence public consumption (which is the purchase of goods and services by the general government sector). First is the winding down of temporary, pandemic-related services such as ‘test-and-trace’. Second, and working in the opposite direction, is the purchase of goods and services to support Ukrainian migrants.
The investment environment has deteriorated, amid tighter financing conditions and heightened economic uncertainty. Businesses will likely hold back on committing to new capital spending while price pressures and uncertainty remain elevated, and this will likely weigh on core machinery and equipment spending. In the housing market, higher input costs will likely continue to weigh on supply, though the government’s National Development Plan 2021-2030 will support activity elsewhere in the construction sector. In overall terms, modified investment is projected to increase by 2.2 per cent next year.
Against this backdrop, MDD growth of 1.2 per cent is projected for next year. The assumed quarterly profile (figure 7B) largely follows that of consumer spending.
Figure 7
Box 2
Export growth is projected to moderate next year to 5.5 per cent, reflecting the weakening in the external environment, though supported by the high-growth sectoral portfolio of Irish exports. The goods export forecast is also based on the purely technical assumption that exports related to ‘contract manufacturing’ do not make a significant contribution to growth next year. Importantly, the projection for the exports of goods is conditioned on the assumption that the introduction of full customs procedures by the UK authorities under the Trade and Cooperation Agreement does not take place between now and the end of next year.
Table 4
On the basis of these assumptions, GDP is projected to increase by 4.7 per cent next year. GNI* growth is expected to increase by just 0.4 per cent, reflecting the modest growth in MDD and a negative contribution of net (domestic) trade in the face of external headwinds.
The government’s policy response to COVID – maintaining the employer-employee link during the different waves of the virus – has underpinned the post-pandemic rapid recovery in employment. The level of employment reached over 2.55 million people in the second quarter of this year, the highest level ever. Increased labour force participation, mainly among female (figure 9A) and youth workers, has been a key factor behind the strong employment recovery. Structural changes, such as greater flexibility afforded by remote-working opportunities, may be a significant factor behind this development.
Looking ahead, higher frequency data indicate some softening in employment growth in the second half of the year. This is consistent with more modest MDD growth, and would result in an average unemployment rate of 5.2 per cent this year. For next year, employment growth is expected to remain relatively subdued, in keeping with the general economic outlook (figure 9B). Growth of 1.2 per cent (32,000 jobs) is assumed, consistent with an unemployment rate of just over 5 per cent for the year.
Figure 9
Despite some expected softening in the labour market over the next year or so, relatively tight conditions and skills shortages for some sectors are likely to persist in the labour market. This, alongside price increases in the economy more generally, is likely to contribute to upward pressures on wages in the near-term.
Table 5
Compensation of employees (the economy-wide pay-bill) increased by just under 10 per cent last year, with new distributional data from the CSO showing that the bulk of pay growth was for higher earners (consistent with the 16¼ per cent growth in income taxes last year). Data for the first half of 2022 indicate that the wage bill is set to increase substantially this year, and the strength of income taxes in the year-to-date supporting this conclusion. Overall, compensation of employees is projected to grow by around 12.3 per cent this year, and by 7.2 per cent next year.
Consumer price inflation has accelerated sharply across advanced economies since the spring, with multi-decade high inflation rates of 9 per cent, 9.9 per cent, and 9.1 per cent recorded in Ireland, the UK and the euro area respectively in August.
In Ireland, the key driver of inflation has been the increase in wholesale energy (particularly gas) prices following Russia’s invasion of Ukraine. As a result, Ireland’s energy import bill (figure 10A) was around €10 billion (annualised) in July this year, double the 2015-2020 average. Moreover, as hedged positions are unwound and prices inter alia reflect gas price developments over the summer, the direction of travel for the import bill is clear.
Other commodity prices, such as those for wheat, fertilisers and metals, also increased sharply in the immediate aftermath of the invasion, but have subsequently retreated somewhat. These external inflationary pressures have been further exacerbated by persistent global supply chain disruptions. On the domestic front, the ongoing mismatch between demand and supply in parts of the labour market is also contributing to higher prices.
Figure 10
Detailed price data confirm that inflationary pressures have broadened beyond energy and food prices: over the summer, annual inflation was in excess of 5 per cent for 80 per cent of goods and services in the basket (figure 10B). Core inflation – which excludes these components – has picked-up sharply, as ‘second-round’ effects take hold (higher input costs leading to higher output prices).
Looking ahead, headline (HICP) inflation is expected to increase further over the second half of this year. As detailed earlier, natural gas prices have increased further over the summer and, as wholesale prices pass-through to retail prices, this will add to inflation. Core inflation is also expected to continue to pick up over the course of this year as the indirect effects of higher energy prices continue to pass through to other sectors, in particular food, transport and non-energy goods. While there is evidence that bottlenecks in global supply chains may be gradually unwinding (figure 4), relatively strong wage growth will keep services inflation elevated. For this year as a whole, headline inflation is projected to average 8.5 per cent, with core inflation of 5.3 per cent in prospect.
Table 6
Some easing of the annual rate is anticipated next year as energy price base effects drop out of the annual rate, supply chain disruptions further unwind and employment growth slows. Despite this easing, the price level will remain elevated, with headline and core inflation of close to 7 and 4.6 per cent respectively forecast for next year. As a result, the price level in the fourth quarter next year is expected to be 13 per cent up on the level in the first quarter this year, with the largest increases for essentials such as rents, food and energy.
The GDP deflator, a wider measure of price changes in the economy, is forecast to grow by 6.5 per cent this year. Given the size of the traded sector in Ireland, the so-called ‘terms-of-trade’ (the price of exports relative to the price of imports) is an important driver of the GDP deflator in Ireland. Rising export prices (partly related to exchange rate developments) alongside rising import prices (mainly due to higher imported energy prices), have led to a small increase in Ireland’s overall terms of trade this year, though a fall in the terms-of-trade is projected on the goods side. For next year, the GDP deflator is projected to increase by 4.4 per cent.
The modified current account (CA*) removes a number of globalisation-related distortions, and is a more meaningful measure of the balance of international payments than the headline current account figure. For this year, the increase in the nation’s imported energy bill – arising from a deterioration in the terms on which Irish residents trade with non-residents (terms-of-trade shock) – will result in some narrowing of the modified current account surplus, which is projected at 8.4 per cent of GNI*. A further narrowing is in prospect next year, with a surplus of 7.7 per cent of GNI* projected.
The counterpart to the modified current account surplus is an excess of domestic savings over domestic investment. This means that the savings of the household, domestic corporate and government sectors are more than sufficient to finance the investment in these sectors and there is, accordingly, a flow of funds from these sectors to the rest of the world – in other words Ireland is, on aggregate, a net-lender to the rest of the world. The department’s economic projections imply an excess of saving over investment over the course of this year and into next (table 7).
These financial positions are expected to unwind over the medium term, in particular as the financial surplus of the household sector is reduced through higher investment housing assets and a more ‘normal’ level of savings.
Medium-term prospects will be determined, as always, by the availability of capital and labour in the economy, together with the efficiency (productivity) with which these are combined to produce output. The department’s projections beyond next year take into account estimates of this supply capacity.
Figure 11
Beyond the mid-part of this decade, the potential growth rate of the economy is set to slow, as labour supply eases and the scope for further increases in labour productivity (output per worker) is limited as the convergence process is completed.
Figure 12
Box 3