Risk assessment forms a central element of my Department's analyses. At present, inflationary pressures in Ireland are more muted than those being experienced in the wider euro area, with end-April Harmonised Index of Consumer Prices data indicating an inflation rate differential of some 0.3 percentage points. Ireland registered an inflation rate of 0.4% compared to the euro area rate of 0.7%. Were a deflationary spiral - a prolonged period of negative price growth - to take hold, this would likely be met by further monetary accommodation by the European Central Bank (ECB) rather than by its reducing interest rates. If, however, a relative inflation differential were to open up between Ireland and the rest of the euro area where prices remain depressed here yet recovered momentum at European level, this would result in a gain of relative price competitiveness for the Irish economy. Given trade exposures to the euro area, however, the cost of imported inputs would increase.
Given that the ECB is effectively constrained in the conduct of its interest rate policy by the current near-zero lower bound of interest rates, if deflation were to take hold without a corresponding offset in policy by the ECB, this could potentially result in an appreciation of the euro exchange rate which would slow euro area growth and pass through to Irish economic dynamics. The impact would be to reduce both nominal and real GDP growth, by lowering consumption and investment volumes as a result of rising real Irish interest rates. There would also be corresponding negative impacts on trade volumes and labour market dynamics.
Quantitative scenario analysis of this type is routinely carried out by the Department of Finance in conjunction with the Economic and Social Research Institute using their NiGEM HERMES model. Risks of this nature are regularly monitored and analysed and input to the conduct of budgetary planning in the form of the scenario analysis is routinely reported in the context of both the Budgetary documentation and the Stability Pact Update. Chapter 4 of the April 2014 Update contains such an analysis.
