In this blog by the NERI Co-director, Dr. Tom McDonnell he discusses the Irish economy over the past few years and refers to his latest NERI Report Series document.
The Republic of Ireland’s economy is in a very unusual position.
The labour market might already be close to overheating, yet real wages and incomes have been falling. Consumer confidence is low yet employment is at a record high. The headline public finances are in strong surplus yet there are genuine concerns about sustainability. Price inflation has been at a multi-decade high. Rapid monetary tightening hasn’t noticeably slowed the economy.
The economy has been beset by a range of shocks. Brexit disruption; the economic rollercoaster of the pandemic; the energy supply shock and cost of living crisis, and now fast rising interest rates and financial market jitters. Despite all of this the economy has proven resilient, at least so far. Labour demand outstrips labour supply capacity in a number of sectors. The housing crisis rumbles on.
What should we make of all this?
The latest NERI Economic Report (no 22) discusses the current economic context and projects ahead.
Our baseline view is that the economy should, on balance, avoid a recession. Improving real incomes, slowing but positive employment growth, and a partial normalisation of the household savings rate are all set to support underlying demand in the near term.
The economy should grow – albeit modestly
Recessionary prospects in most trading partners are fading, notwithstanding concerns about the global financial sector. We anticipate that the trading sectors of the economy will benefit from the improving international conditions. Strong export growth from the multinational sector boosted growth in 2022 and this is likely to continue, albeit at a slower pace.
However, Ireland’s export performance is subject to significant uncertainty and volatility due to its high level of concentration in pharmaceuticals and ICT and the large impact of globalisation effects such as contract manufacturing. The uncertainty in the global financial sector may impact on the overall level of FDI into Ireland.
While headline inflation rates are trending down in the Euro area, core inflation could become sticky, and it remains on an upward trajectory. There appears little prospect the current phase of monetary tightening has finished. We expect a further two and perhaps a third 0.5 per cent increase this year. Monetary tightening will increasingly weigh on consumption and investment decisions over the short-term. Notably, the higher cost of credit may act as a brake on investment in housing supply. In addition, the temporary fiscal policy supports are unlikely to be renewed in Budget 2024 and a more countercyclical or at least neutral fiscal stance will weigh on demand in late 2023 and into 2024.
Muted PMIs and confidence indicators imply only modest growth this year. The still-high savings rate (double its pre-pandemic rate) and the unwinding of savings offers scope for consumption to remain relatively buoyant this year. Weak consumer confidence my temper this process and full normalisation of the savings rate is unlikely in the short-run.
The supply-side and cost of living challenges seen in recent years should diminish in 2023 while the tight labour market will drive real wage growth. The increase in real disposable household income will support demand. Retail sales growth has held up well in the first two months of the year. Our projection is that modified domestic demand will grow by 2% to 2.5% in 2023 and then by a further 2.5% to 3% in 2024, buttressed by real wage growth, employment growth and a declining savings rate.
The economic risks are weighed to the downside and include weaker than expected trading partner growth, further shocks to energy prices, and prolonged and aggressive monetary tightening due to sticky core inflation.
In addition, the ongoing housing supply crisis may start to weigh on employment growth via reduced investment into Ireland, falling competitiveness, and constraints on internal labour mobility.
Price inflation should ease
The decline in price inflation in the US should be replicated in Ireland and the Euro area over coming months and quarters. The global economic outlook in terms of commodity prices suggests a downward trend in prices. While headline inflation is likely to continue its downward trajectory, the pace of that decline remains highly uncertain, with the transmission of monetary policy onto demand still unclear in terms of lag and size of effect.
Supply and demand mismatches are becoming less pronounced although procyclical fiscal policy could prolong high inflation. Second order dynamics have yet to significantly manifest via wage growth though this may change given the tightness of the labour market.
Notably, core inflation has yet to decline. We envisage that the process of core inflation normalising will begin in the near future, albeit core inflation will decline at a slower pace than headline inflation. Core inflation becoming stuck is a downside risk to the outlook as it would induce further monetary tightening.
Real wage growth will return this year
The labour market is performing very strongly and would be close to capacity in the absence of ongoing inward migration. There is little evidence of scarring from the Covid pandemic due to the successful policy response to that crisis, while the composition of employment has generally shifted to higher value-added activities. Labour supply issues are already evident in a number of areas including the broad construction sector.
While employment growth will not match the unsustainable levels seen in recent years and job vacancy rates have started to slow, we anticipate that net employment gains will be sufficient to keep the unemployment rate at close to 4%. The tight labour market and a lagged ‘catch-up’ with a high but falling inflation rate implies real wage growth this year and next. Wage growth should be close to 6% this year and 5% in 2024, albeit with the usual variation between sectors.