Monday 5 August 2019

The economic environment.

The Irish economy has continued to grow at a strong pace, supported by the buoyancy of domestic economic activity and strong growth in exports, despite the rise in uncertainty about economic prospects and increasing external headwinds.

On the domestic side, the strong growth momentum has been underpinned by continued robust and broad-based growth in employment and increasing earnings, while also being supported by continuing favourable financial conditions and further improvement in the financial situation of households and businesses. As a result, consumer spending, even though held back a little by uncertainty, has grown strongly, while the rebound in some key components of domestic investment, such as building and construction, has continued to gather pace. On the external side, despite a less favourable international economic environment, export growth has surprised on the upside, although it is notable that growth has been concentrated in a small number of sectors, dominated by multinational firms.

Looking ahead, the outlook remains positive but subject to heightened levels of risk and uncertainty. The Central Bank’s central forecast, prepared on the basis that a disorderly, no-deal Brexit can be avoided, is that underlying economic activity will grow at a relatively solid pace in coming years, though some moderation in growth is in prospect in 2019 and 2020. The projected moderation in growth reflects both the dampening influence of the less favourable global growth outlook and the gradually limiting impact of emerging domestic capacity constraints.

In the central forecast, the main impetus to growth in 2019 and 2020 is expected to come from the continued expansion in underlying domestic demand, reflected in solid growth in consumer spending and underlying investment (which excludes the volatile categories of investment in intangibles and aircraft). The expansion in underlying activity over the forecast horizon is projected to be driven by continuing gains in employment and incomes, though a moderation in employment growth from its recent very strong growth rate is projected over the forecast horizon. Nevertheless, and reflecting the impact of the stronger recent data, this implies annual employment growth 0.3 per cent higher for this year than in the projections published in the last Bulletin. On the external side, export growth is forecast to grow more in line with moderating demand in Ireland’s main trading partners, though net exports are projected to continue to contribute positively to growth over the forecast horizon.

Reflecting the resilience of both domestic demand and export growth in the first half of 2019 and the recent strength for employment growth, the central forecasts for 2019 and 2020 have been revised upwards compared to those published in the last Bulletin. Largely as a result of higher forecasts for consumer spending in 2019 and 2020, underlying domestic demand is now projected to grow by 4.4 per cent this year and 3.3 per cent in 2020, upward revisions of 0.4 per cent and 0.1 per cent, respectively. Allied to some increase to the export growth forecasts, to take account of strong recent data, GDP is now projected to grow by 4.9 per cent in 2019 and 4.1 per cent in 2020, which is 0.7 per cent and 0.5 per cent higher, respectively.

However, there are material domestic and external risks to this forecast. On the external side, Brexit remains the most salient risk. In the January 2019 Quarterly Bulletin, the Bank set out its estimate of a disorderly, no deal Brexit on the Irish economy. While uncertainty necessarily attaches to an exercise of this type, the estimates suggest that such an outcome would reduce output growth by 4 percentage points in the first year, with output lower by 6 per cent after 10 years, compared to a no-Brexit scenario. These estimates remain unchanged and Box B (page 23) in this Bulletin applies this analysis to look at the possible implications for the central forecasts of a disorderly, no-deal UK exit from the EU on 31 October 2019. The results imply that GDP growth for 2019 would be reduced from 4.9 to 4.5 per cent, while in 2020 growth would fall from 4.1 to 0.7 per cent. With regard to other impacts, the estimates suggest that, by the end of 2020, there would be around 34,000 fewer jobs in the economy compared to the level of employment projected in the central forecast, while the General Government Balance-to-GDP ratio would be around 0.75 per cent worse.

On the external side, in addition to Brexit, risks in relation to international trade and taxation persist and, given the important role of multinational firms within the economy and the growing concentration of export growth, it is important to build the resilience of the economy to possible shocks to the sector.

On the domestic side, the recent strength of growth in output and employment have further elevated the cyclical position of the economy, eroding already limited domestic spare capacity (See Byrne, S. and T McIndoe Calder (2019): ‘Employment growth: Where do we go from here?’). In the event that a disorderly, no deal Brexit can be avoided, underlying economic activity is expected to perform strongly in 2019 and 2020. Given the already cyclically advanced stage of the economy, there is a material risk that continued strong expansion could give rise to overheating and generate sustained upward wage pressures. An article published in this Bulletin, ‘Modelling Overheating Risks in the Irish Economy’, examines this issue. It shows that rising wages in an upturn could lead to boom-bust dynamics, in the form of a subsequent loss of competitiveness and a fall in output, if wages are not flexible downwards when buoyant economic conditions dissipate. While an increase in inward migration can help to mitigate overheating dynamics in the labour market, at the same time, it can create higher demand and generate additional pressures in other parts of the economy. Appropriate macroeconomic management can help navigate these challenges and fiscal policy can play an important role in containing excess demand and avoid placing excessive strain on an economy operating close to capacity.

The current constellation of risks and uncertainties facing the economy increases both the challenge and importance of charting the appropriate fiscal policy path. If a disorderly Brexit can be avoided, the underlying outlook and, in particular, the risk of overheating, emphasises the importance of a more ambitious improvement in the fiscal position. With output at or close to potential, a tighter fiscal policy would help to manage demand pressures. The uncertain environment also highlights the necessity of reducing the dependence on potentially transitory revenues to fund lasting spending commitments. It would be more prudent to save rather than spend windfalls to mitigate pro-cyclical dynamics and build buffers to facilitate a stabilising countercyclical fiscal expansion in the event of a future downturn. Failure to run sufficient surpluses during phases of good economic performance may limit the room for manoeuvre in the future. The current strong economic performance is to be welcomed but, to ensure that the economy remains on a sustainable growth path, it is important that fiscal policy be pro-active in mitigating pro-cyclical dynamics.

If a disorderly Brexit were to occur, on the other hand, there would be a material deterioration in the fiscal position and the fiscal environment would be significantly more challenging. In addition to allowing the regular automatic stabilisers to operate fully, there may also be the need to provide temporary and targeted support to the sectors most affected. In the case of a wider, more severe economic impact, it may be appropriate to provide a broader fiscal support package. It is important that any fiscal response is consistent with long-run debt sustainability and does not undo the hard work in re-establishing Ireland’s fiscal credibility and risk the emergence of unsustainable debt dynamics.

Central Bank of Ireland Quarterly Bulletin No.3 2019

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