ECB rate rise will hurt but not as much as in the past

The first ECB rate rise in over a decade was universally expected later this year and it is now likely to be announced on the 21st July. The most recent data has led to the capitulation of the more dovish Council members, with its combination of record low euro area unemployment, another fresh high in the headline inflation rate , at 7.5%, and a big jump in the core rate, to 3.5%.

The market has been pricing in higher rates for some time although expectations are volatile and at the time of writing longer term rates have fallen from the recent highs, albeit with 1-month euribor still priced at 1.25% by end 2023, or over 1.75% above the current level. For this year, three quarter point increases are fully priced in, taking rates well into positive territory by Christmas.

Higher money market rates will eventually feed through into retail rates but the impact on Irish households may well be less painful than in the past. First, rates are much lower than at the beginning of previous tightening cycles – the average rate on outstanding mortgages is currently 2.45%, including a variable rate average of 2.16%. Second, household debt here has been falling for 14 years and is now down to 98% of household disposable income, against well over 200% at the peak of the Tiger era. Third, in the aggregate households now have far more cash and deposits than debt, with the gap widening to €54bn in the final quarter of 2021.

A fourth factor relates to the mortgage market itself which in the past was largely based on variable (floating) rate debt, meaning a relatively quick pass-through from wholesale rates to most borrowers. In recent years that has changed as around 85% of new loans are fixed, with the majority over three years. Over time, the proportion of outstanding mortgages on variable rates has fallen and is now down to 50%, against over 90% when the ECB last raised rates in 2011.

Irish fixed rates are generally on a shorter term than the EA norm and so over the next few years many will have to revert to a new fixed rate or to a variable and both are likely to be higher, although given the hit to real incomes from inflation (now 7%) a few years respite will be welcome.

Although an ECB rate increase looks inevitable now, the impact on Ireland, at least initially, will also depend on which rates the ECB choose to adjust. Short- term money market rates are currently tied closely to the ECB deposit rate, at -0.5%, and that will move up in order to push up market rates. The refinancing rate is zero and the spread between the two rates has varied historically, from 0.25% to as wide as 1%, so it is not a given that the refinancing rate will also move up in July, although on balance that appears most likely.

When the refinancing rate moves may be open to debate but not the impact here as 30% of outstanding mortgages are on Tracker rates i.e. at a fixed spread over the refinancing rate. That percentage has been falling steadily as mortgages mature (it was still as high as 50% in 2015) and the average rate has been extraordinarily low for some time (1.05%) but if the refinancing rate does rise by 0.75% by year-end that will increase Tracker rates by the same amount.

One final point . Two major mortgage lenders are leaving the market which all things equal will reduce competition for loans, although a number of new niche lenders appear to be picking up market share in terms of new lending. How mortgages are funded is key though, and the remaining banks have a huge pool of excess deposits, paying zero or even negative rates , to call upon, against other lenders who are solely reliant on market rates .Ultimately higher market rates will be passed through but the timing may vary depending on that funding mix; new Irish mortgage rates rose in March, as across the EA, but with a difference in that here new fixed rates were unchanged and the increase was in variable rates.

Measuring Irish Inflation

Eurostat publishes inflation rates for the EU and the euro area each month and also issues a flash estimate for the EA , normally around two weeks before the final release. The flash figure now includes all EA member states, so an estimate for Ireland is available ahead of the official release here by the CSO.

The estimate is for the Harmonised Index of Consumer prices (HICP) , the official EU measure , which can differ from the domestic measure as used by the respective member states. For example, German inflation in April was 7.4% on their Consumer Price Index (CPI) against 7.8% on the HICP measure.

Most CPI are similar in terms of general components but differ in regard to measuring specific items, notably housing costs. The idea of the HICP is to use a standard methodology , so some items included in the CPI may be excluded from the HICP and this will also impact the component weights.

In Ireland’s case the CPI has a number of largely service items excluded from the HICP, amounting to over 6% of the CPI. These include the Local Property Tax, motor and dwelling insurance, motor tax and building materials. The most significant exclusion though is mortgage interest which has a weight of 2.76% and that component largely explains any significant difference in the two indices over time ,although that has not been a feature in recent years.

For example, the annual inflation rate in March on the CPI reading was 6.7% against 6.9% on the HICP measure. Two components,Housing and Transport, made a 5.2 percentage point contribution to the CPI (i.e. accounting for 78% of the total inflation figure) while the corresponding contribution to the HICP was 5.3 percentage points or 76%.

The difference can be sizeable though in periods when the ECB is changing its policy rates. For example, mortgage rates plunged through 2009 and Irish CPI inflation that year was -4.5%, against -1.7% on the HICP measure. As we now appear to be on the cusp of a tightening cycle from the ECB it is likely that CPI inflation will be higher than the HICP equivalent in the next few years as variable mortgage rates are still the dominant factor in outstanding mortgages here, despite the popularity of fixed rates in new mortgage loans.

The CPI is the ‘official measure of inflation for Ireland’ according to the CSO so in that context it is curious that rent controls last year were initially linked to the HICP and not the CPI, with the former not capturing any change in mortgage costs. The surge in inflation in 2021 prompted a change anyway, with the limit at a max of 2% or the HICP inflation rate if lower, which implies a significant fall in real rents given the inflation outlook, particularly if using the CPI as deflator.

Tax surge transforms Irish fiscal outlook

The 2022 Budget, delivered last October, projected a €7.7bn Exchequer deficit , largely due to high capital spending by the State, with a capital deficit of €11bn offsetting a €3.3bn current budget surplus. The projections were predicated on real GDP growth of 5.0% and price inflation of 2.2%, with tax receipts forecast at €70.2bn, which implied a very modest rise of 2.6% on the 2021 out turn.

Tax receipts grew by by an annual 32% in the first quarter of 2022, so it was clear that the Budget forecast was redundant, in part because inflation was much higher than envisaged, so boosting expenditure based taxes and income tax. The Department of Finance normally publishes in February a monthly profile of expected tax receipts but that has not appeared, also indicating that a significant revision to the initial fiscal outlook was likely. That has now duly emerged in the form of the Stability Programme Update (SPU) which is mandated each April for EU member states.

Tax receipts for 2022 are now projected at €75.8bn, which is €5.6bn above the Budget forecast and 11% higher than the 2021 out turn,reflecting much higher than expected receipts from Income tax, VAT and notably Corporation tax, which yet again has surprised to the upside. The only heading seeing a fall is Excise , due to the cut in duty on fuel. Non-tax receipts are also now above the initial target while current spending is broadly as planned, so giving a current budget surplus of just under €10bn. Capital spending is expected to be larger due to higher prices but offset by stronger capital receipts (reflecting the sale of bank shares by the State) leaving the capital deficit marginally lower than planned at €10.8bn.The net result is a projected Exchequer deficit of just €1bn, and a broader General Government deficit of €2bn or 0.4% of GDP (the initial target was €8.3bn , 1.8% of GDP).

The outlook for Ireland’s debt also looks even more positive in these new projections even though the debt dynamics were already favourable given that the interest rate on the debt is substantially below the growth rate of GDP. In 2022, for example, the economy is now forecast(in the SPU) to grow by 11% in nominal terms against a 1.5% interest rate on the debt, which leads to a large fall in the debt ratio, to 50.1% from 55% ,as the primary fiscal budget (the actual balance excluding debt interest) is actually in surplus. The latter is forecast to increase out to 2025, which helps to generate a debt ratio of under 41% by that year.

In fact some of the commentary on the debt interest bill is misleading, as it is projected to fall, not rise, declining to €3bn in 2025 from €3.6bn this year. This may seem counterintuitive given the recent rise in Irish bond yields (the 10 yr yield is currently at 1.45%) but the interest bill is largely determined by the cost of new bond funding (largely at a fixed rate) relative to the interest rate on the maturing debt. From 2023-25 the coupons on the maturing bonds range from 3.4% to 5.4% so it would require much higher current rates (and much higher borrowing) to prevent an ongoing fall in the interest bill, although that does start to reverse from 2026 as bonds issued in the very low rate environment start to mature.

These forecasts may not emerge as planned of course but as it stands Ireland is set to run a very large current budget surplus and an overall budget excluding debt payments also in surplus, which alongside a falling debt ratio does not support the view that the debt is a big issue.

Irish GDP growth to slow to 4.5% this year, with inflation seen at 5%

The Irish economy as measured by real GDP grew by 20% over the pandemic years 2020/21, expanding by 13.5% last year following a rise of 5.9% . The final quarter saw a substantial contraction, however, of 5.4% , and a combination of negative base effects over the first half of 2022 , much higher inflation and the negative impact of the Russian invasion of Ukraine on asset prices and economic activity has prompted us to reduce our forecasts for growth this year to 4.5%. That could prove optimistic if crude oil and gas prices spike higher , thus having a much more significant impact on real household incomes.

GDP growth last year was again largely driven by exports, recording a 16.6% rise including over 20% from merchandise exports. The latter includes contract manufacturing, goods produced abroad (mainly China) for an Irish domiciled company, and the impact of this production is now extremely large; total merchandise exports last year amounted to €283bn with €165bn actually produced in Ireland.

The export figure alone would have delivered GDP growth of 20% and that was partially offset by another large fall in capital formation , declining by 38% following a 23% contraction in 2020. Construction fell again , by 3.5%, although the decline in house building was modest, largely reflecting a Lockdown in the first quarter. Investment in machinery and equipment did recover strongly, up 24%, but that was swamped by another huge fall (55%) in Intangibles. The latter includes spending on R&D and Patents by multinationals and is broadly GDP neutral as it is also captured as a service import.Consequently total imports fell, by 3.7%, with a large decline in service imports offsetting a recovery in merchandise imports.

Consumer spending had fallen sharply in 2020, by 10.7%, and a recovery was expected, supported by the build up in ‘forced savings’ evident through the pandemic. In the event the recovery in consumer spending was relatively modest , at 5.7%, with the decline in the savings ratio rather less pronounced than some envisaged; the third quarter figure was 16.7% against 21% a year earlier. Government consumption growth (5.3%) was similar to that of households but in contrast slowed from the double digit pace of 2020.

Nominal GDP in 2021 grew by 13.1% to €422bn, so flattering the fiscal ratios; the fiscal deficit is now put at 2.1% while the debt ratio appears to have fallen to 56% from 58.4% in 2020 (the end-year debt figure has yet to be confirmed). GNP, which adjusts for profit and interest flows in and out of the economy, also grew very strongly in real terms, by 11.5%. The CSO also publishes a figure for modified domestic demand (which adjust for some multinational spending on headline capital formation) and that grew by 5.5% last year, although it excludes all exports and takes no account of how that demand is satisfied ( i.e. from domestic or imported output).

Base effects play an important role in any forecast for GDP and the carryover effect in 2022 is lower than we expected, as GDP fell by 5.4% in the final quarter of 2021, reflecting a substantial rise in imports. Capital formation also rose but export growth was weak and consumer spending actually fell. Given also that the growth surge seen in the first quarter last year is unlikely to be repeated we now forecast a substantial slowdown in Irish growth this year, to 4.5%. Exports, as always, will largely determine the GDP figure and we expect a much weaker trade performance given an expectation of slower growth in Europe and the US with supply issues evident in China. Building and construction ,in contrast, is forecast to recover strongly,growing by 12%, boosted by housebuilding, with a more modest increase expected in overall capital formation on the assumption that Intangibles grow after two successive annual declines.

Households will also face a much more difficult year, with real incomes eroded by much higher CPI inflation. That averaged 2.4% last year but spiked in the latter months of the year and into 2022, with the February figure at 5.6%. The surge in the CPI was largely due to two components (Housing +Utilities and Transport) and hence largely energy related but the most recent data showed the beginnings of a broader increase ( albeit also impacted by the minimum pricing on alcohol introduced in January) reflecting energy costs on producers, supply issues and the impact of the fall in the euro, notably against sterling. The March figure will capture another surge in fuel costs following the Russian invasion of Ukraine and we now expect inflation to average 5% this year, although this assumes a stabilisation in oil and gas prices and so the risks to that projection are to the upside. As a result we now expect consumer spending to rise by just 2% in real terms this year.

The Labour market reveals a more positive picture, with the total number employed surpassing 2.5 million for the first time in the final quarter of 2021, following an annual increase of 230,000.The unemployment rate is back down to around 5% and with a record vacancy rate Ireland is around full employment, with labour scarce and jobs plentiful. In 2022 we expect the unemployment rate to fall marginally to 4.8% , with employment growth of 115,000. The tightness of the labour market may also help to maintain weekly earnings growth at around 5% in 2022 (fro 4.8% last year).

On the fiscal side tax receipts have surprised to the upside relative to Budget projections in each of the past four years. Last year receipts grew by 20% and exceeded the initial Budget target by €8bn and this year (at end-Feb ) were still rising at a similar annual pace. The 2022 Budget envisaged a 2.6% rise in receipts by year end so a much lower deficit than projected is on the cards, with a large capital deficit offsetting a substantial current budget surplus . The Government may well revise the fiscal targets but also has the scope to take further action to offset the impact of higher energy prices on households, having already introduced a rebate on electricity bills and a (temporary) cut in excise duty on fuel at a total cost of over €800m. Nonetheless the fiscal deficit may fall below 1% of GDP, with the debt ratio declining to 52%.

Irish Housing Market Update

  1. The housing stock per head is still falling

Housing completions in 2021 amounted to 20,433 which is marginally down on the previous year and lower than the prepandemic figure of over 21,000 in 2019. This means that the housing stock is rising by around 1% a year and as such below the growth in population so the housing stock per head is falling, and has been declining since 2008.Planning permissions are running at around an annual pace of 40,000 and although not translating on a consistent basis into actual builds we expect completions to pick up strongly this year, to 25,000 and as such outpace the rise in population.

2.Employment growth is very strong

Housing demand is driven by household income growth , in turn strongly impacted by changes in employment. Ireland is again close to full employment with the vacancy rate at record levels .The Government’s fiscal support during the pandemic helped support the housing market by preventing a fall in household incomes, and employment in professional and other higher income occupations continued to rise.

3.House price growth is in line with fundamental models

There are various approaches to modelling house prices and we prefer a simple fundamental model comprising household income , the housing stock per head and real mortgage rates.The model tracks actual prices fairly well and does not point to a fundamental overvaluation (prices are actually modestly below fair value in the model ) and values should be rising given a combination of weak supply and rising employment and incomes. The predicted rise in 2021 was 6.7% (it is the annual average ) against the 8.3% outcome as per the CSO residential property price index . For 2022 the forecast is 10.0% which given that price inflation ended 2021 at 14.4% implies an end-2022 figure of around 6%, with the deceleration largely due to our expectation of a significant increase in housing supply.

4. Mortgages are still affordable relative to the long term trend.

The average new mortgage for house purchase in 2021 was just under €250,000 which assuming a 25-year term equates to €1150 a month given the average mortgage rate last year. That is actually well below the average monthly rent nationally and on our affordability model amounts to 26% of gross income. The long term average (going back to 1975) is 28.5% so on that basis affordability is by no means stretched, although the issue for many is accessing a mortgage and a property to buy. It is also noteworthy that the average loan to value appears to be falling, meaning higher deposits from buyers, no doubt reflecting the Help to Buy scheme and the scale of ‘forced’ savings during Lockdowns.

5. New Mortgage lending to rise to €13.6bn this year

Gross mortgage lending amounted to €10.5bn last year according to data from BPFI, which was over €2bn up on the previous year and the strongest annual figure since 2008.Switching has picked up but most lending is for house purchase, amounting to €8.6bn, with two-thirds of that going to First Time Buyers. In the coming year we expect the forecast rise in house completions to drive a significant increase in the number of mortgages for house purchase ( to 42,000 from 35,000 last year) which allied to higher house prices yields a figure of €11.4bn for house purchase. Total mortgage lending is projected at €13.6bn.

6. Net lending is positive again but weak

Perhaps the most striking aspect of the current house price boom is that it is not being driven by credit, as on past occasions.This in part reflects the impact on leverage from the Central Bank’s mortgage controls, with the average Loan to Income at 3.3 which is the lowest in the euro area. Institutional buying is also significant but households are repaying debt as mortgages from the previous boom mature. The result is that net mortgage lending last year rose by just €850m, or 1.2%, which is well below the euro average figure of 5.4%. The projected increase in gross lending should help to boost the net figure in 2022 and we expect an end-year increase of 3.5%.

7. Rent rises also unsurprising

Using data from the CSO on private rents actually paid, last year saw a marked change in the market; rents nationally were falling on an annual basis in the first few months of the year before picking up sharply to an 8.4% annual increase by December. Again this is in line with our fundamental model, driven by employment and the housing stock, although our projected rise in house completions does feed through into a slowdown in rental growth in 2022, to 4% by year-end. This may be an underestimate though, as it would appear that the supply of rental properties is being adversely impacted by rent controls

8. Mortgage rates may rise.

85% of new mortgages are on a fixed rate and that trend has been in place for some time now, so impacting the stock of outstanding mortgages and making the market less sensitive than it was to changes in ECB rates. Nonetheless , just over half the existing mortgage debt in Ireland is on a variable rate, with the majority of those loans on a Tracker rate, which moves with the ECB’s refinancing rate.The prospect of an increase in the latter has increased as the ECB now appears inclined to tighten monetary policy this year although any initial moves would be via the deposit rate, which would impact new variable rates and new fixed rates. Nothing is set in stone as yet but it is likely that borrowers will face higher rates for new loans by the autumn or earlier, with Tracker rates moving up in 2023.

ECB opens door to rate increases.

Today’s ECB press conference (3 Feb 2022) marked a very significant change in ECB rhetoric, and it now looks far more likely that interest rates are on the way up; the market is currently priced for short term rates to be 0.3% higher by year-end and to turn positive by the spring of 2023.

That may or may not materialise but it is clear that the recent upside surprises to EA inflation has shaken the ECB’s previous belief that inflation would fall steadily in the early months of 2022. That view had prompted President Lagarde to state that it was ‘highly unlikely’ that rates would rise at all this year, but when asked she refused to reiterate that line, arguing now that ‘the situation had changed’ and that the ECB was data dependent. Lagarde also noted a few times that the unemployment rate in the EA had fallen to a historic low of 7%, thus raising the risk of ‘second round’ effects i.e. higher wages feeding into higher costs and prices.

Inflation is now deemed subject to ‘upside risks’ and given that and the overall hawkish tone it was odd to see that the monetary policy statement still included the line ‘the Governing Council expects the key ECB interest rates to remain at their present or lower levels‘ (my italics), presumably an oversight.

The March meeting now assumes greater importance, as that will include updated Staff forecasts. The inflation projection for this year will almost certainly be revised much higher(it was 3.2% in the last forecast) but the crucial factor will be the figure for 2024, which was 1.8% and hence below target but could now move up to 2% or above.

The timing of any rate increase is complicated somewhat by the present ECB commitment to end QE before raising rates. The PEPP ends next month but as it stands there is no end-date fixed for net asset purchases, which from October are set at €20bn a month. So to raise rates this year the Governing council would first have to terminate net purchases.

What does this mean for Irish mortgage rates?. Any initial moves by the ECB would be through the deposit rate, which would affect market rates and hence new variable mortgage rates and new fixed rates. The refinancing rate, which affects Tracker mortgages would be unchanged initially but would probably rise as well as we move into 2023. This is not set in stone and weaker economic growth or a spike out in government borrowing costs might change things, but as its stands it appears the ECB is likely to tighten monetary policy sooner rather than later.

Modified Domestic Demand is not a measure of Irish Economic activity

The impact of multinationals on Irish GDP has in recent years prompted the CSO to publish other measures which are deemed to better capture ‘real’ economic activity and income in Ireland. Although not recognised internationally, these concepts are now often used by the Department of Finance, the Central Bank and some private sector forecasters in their projections.

One such measure is Modified Domestic Demand (MDD) but it is not a useful or indeed meaningful concept in terms of the output and income of the Irish economy.. Lets start with domestic demand itself, which is simply the total spending on goods and services by consumers and the government plus capital formation. The latter captures spending on construction, investment by firms on machinery and equipment, plus what is termed Intangibles, defined as spending on R&D and the creation of Intellectual property. This spending used to be seen as a cost but under revised National Accounts definitions is now included in the GDP figure as a source of capital creation.

To give some context, taking figures for 2020, personal consumption amounted to €100bn, government consumption was €40bn and capital formation €148bn giving a total of €288bn. The value of stocks produced but not sold is also added (€5bn), so MDD amounted to €293bn in that year. Note though that the stock component is small but is a production rather than a spending figure, unlike the other three.

Yet some of that domestic spending went on imports (i.e. goods and services produced elsewhere) which is precisely why total imports are deducted from the GDP figures to avoid inflating the amount of goods and services produced here. To say , therefore, that domestic demand will rise by 10% tells us nothing about where that demand is met from- will there be a huge boost to Irish firms or will that demand be satisfied by firms abroad. Similarly no account is taken of exports. It is one thing to argue that some multinational exports help to overstate Irish income and output but another to ignore all exports from whatever source, be it from indigenous firms or multinationals; €150bn of exports in goods alone were shipped out of this country in the first eleven months of last year.

Then comes the modified bit. The capital formation figures, as noted , include spending on Intangibles, which in Ireland are dominated by multinationals, extremely volatile even on an annual basis and exceptionally large. They boost capital investment but in effect have little impact on total GDP because most are service imports ( and hence take a negative sign in the GDP sum). While other imports are ignored the CSO modify the domestic demand figure by deducting R&D and Intellectual property imports, amounting to €100bn in 2020. One final deduction is made, which is the value of aircraft relating to leasing , although much smaller in impact, at €9bn in 2020. As a result modified capital formation drops to only €38bn (from €148bn) so MDD in total is reduced to €183bn from the original €293bn. GDP in that year was €373bn.

One argument put forward in defense of MDD is that it is highly correlated with employment, which is true, but the correlation between employment and GDP over the past decade is also very high, at 0.97. It is simply not a measure of output or income in Ireland, or even the output of the domestic economy. One final point: forecasting Irish GDP is difficult enough, but good luck in projecting spending on intangibles, which is the main modification in the MDD concept.