The ECB has managed to tighten monetary policy.

The ECB had flagged that its September meeting would deliver further monetary easing but it is testimony to the difficulty in managing market expectations that the net result is that policy is now actually tighter . That may change,of course, depending on how events unfold over the coming months but as it stands market rates have risen, as has the currency and short term bond yields, and excess liquidity in the market  has  actually declined.

Perhaps the most striking change announced by President Draghi was on forward guidance, with the pledge to keep rates at the current level or lower now no longer time dependent but open ended till the inflation target is achieved.The Bank had also spent most of the past five years denying that negative rates were having a materially adverse effect on the banking system but changed tack, with the introduction of a tiering system on deposit rates. Banks are required to maintain a given level of required reserves , currently €132bn, and these are remunerated at zero percent, the main refi rate. Excess liquidity, which stands at almost €1,800bn , is paid at the deposit rate, which at -0.4% cost banks over €7bn a year. The change now means that banks can hold almost €800bn at the zero rate, but still leaving around €1,100bn in excess,  now remunerated at -0.5% i.e. a cost of €5.5bn.

Some relief then for banks ,albeit one that was below market expectations, but the ECB also eased the terms on its latest long term loans package for EA banks (TLTRO III), which is now for up to three years at a rate equal to the main refi rate over the period, which is likely to be zero. Indeed, as with the other TLTRO’s, banks that grow their eligible lending by over 2.5% by end-March 2021 will pay the deposit rate, currently -0.5%. From an Irish perspective it should be noted that eligible loans exclude mortgages, which are the dominant lending for domestic banks.

The ECB also announced that QE will recommence  in November at  €20bn per month, with no set end-date, although it is likely the 33% limit would be hit in many countries after a year or so. The market reaction to all this may change when QE kicks in and when we have seen a number of TLTRO’s but to date policy is tighter than before the meeting; 3-month euribor for December is trading at -0.42%, from -0.54%, while the figure for December 2020 is -0.5% from -0.62%. The outlook for fixed rate mortgages has also changed as  5 year swap rates have also moved higher, to -0.35% from around -0.5% a few weeks ago.

The euro exchage rate, as measured by the effective or trade weighted index, has also appreciated, which one doubts was a policy aim, while short term bond yields have actually risen;  the German 2-year was -0.81% and is now -0.70% with the Irish equivalent rising to -0.49% from -0.64%. Banks are the main buyers of this debt and it is less attractive because they can now hold more reserves at a zero rate.

It’s early days, but the first TLTRO 111 actually reduced liquidity. Banks had borrowed €740bn under the previous scheme which with early repayment had fallen to €692bn, with another €32bn due for repayment next week. The take up of today’s first TLTRO III was only €3.4bn , implying a net drain of €29bn. Banks have had little time to prepare and no doubt the take up will improve but it is still a remarkable result.

The market had clearly priced in a lot from the ECB but one doubts that the Governing Council will be pleased by the result, an effective  monetary tightening. For prospective  Irish mortgage borrowers the result is also likely to mean less downward pressure on rates.

Irish growth averages 6.6% in first half of 2019

The Irish economy grew by 0.7% in the second quarter, following an upwardly revised 2.7% in q1  (from 2.4%) . The figures left  the annual change in q2 at 5.8% from 7.4%, indicating average growth of  6.6% in the first half of the year. Absent revisions, this implies that GDP would have to contract  over the final two quarters to achieve the current 4.4% consensus for full year growth.

As is often the case with the National Accounts the globalised nature of Irish GDP threw up another weird and wonderful figure for investment in intellectual property, with the import of business services ( which captures that component) rising by over €36bn in the quarter and by €38bn over the previous year, As a consequence total imports jumped by 43% in q2, bringing the annual increase to 61%. This surge is  neutral for GDP however, in that imports are either consumed or invested and in this case contributed to a 182% increase in capital formation in the quarter, no doubt largely due to spending on Intangibles. In fact the CSO did not give a figure for spending on that component  for ‘confidentiality reasons’ implying one or two large firms were responsible.

We do know that spending on building and construction rose by 5.6% in annual terms in q2 and that the pace of expansion there is slowing- indeed spending was broadly flat in the quarter itself when adjusted for the normal seasonal upswing. Spending by domestic firms on machinery and equipment has also slowed but picked up some momentum in q2, rising by 3.6% in the quarter.

Robust government spending has been a feature of the economy of late and that is evident in 2019, with annual growth in government consumption averaging 4.1% over the first half of the year. This is outpacing consumer spending of 2.8%, and the latter is also  lagging  household income growth, implying a rising savings ratio; the past year has seen a remarkable increase in household deposits, despite virtually zero rates of return.

A large run down in inventories was also a feature of the q2 data, and the main driver of  overall GDP growth was again the export sector, witha 2.8% increase in the quarter bringing the annual rise to over 10%. This includes offshore contract manufacturing and the latter has been on a softer trend over the past year, perhaps indicating that trade tensions are having an impact. None the less  the aggregate figure is still remarkably strong.

The  high frequency data  has pointed to some slowing in the pace of activity of late; unemployment has risen in recent months, retail sales have fallen, credit growth has eased and confidence surveys have plumged. This is likely to be largely Brexit related and as such a prolongation of the uncertainty regarding the outcome is a main negative for the outlook, at least in terms of domestic demand. However domestic spending is now small in relation to GDP ( consumer spending accounts for less than a third for example) , albeit important for employment, so it will be the  export picture that will determine what happens to the overall growth rate.

 

 

Every Irish Budget since 2008 has been Contractionary

The Irish Budget gets much media attention and the process itself is now more transparent than in the past, although the net impact on demand in the economy is generally small and certainly far less important than developments in employment and wages. Indeed, given the scale of mortgage debt in the economy and the prevalence of variable mortgage rates ( declining as a share of the market now but still dominant in terms of outstanding debt) monetary policy has had a far bigger impact, particularly in recent years, and it is surprising that the actions of the ECB and our own Central Bank does not receive more scrutiny from the Oireachtas.

The stance of fiscal policy ( i.e. is the Budget adding to demand in the economy or reducing it) does get attention from the economic community and a standard criticism of fiscal policy in Ireland is that it is pro-cyclical , meaning that the Government tends to boost demand in an already strong economy by  cutting taxes and/or raising expenditute. What is therefore surprising is that an examination of the evidence shows that every Irish budget since 2008 can be said to have been contractionary, at least as delivered by the Minister ( the outcomes are often quite different)

The change in the actual budget is not a good measure of the fiscal stance as the General Government balance is itself  impacted by the economy; tax receipts will  rise in a boom, for example, and fall in a recession, with the reverse operating in terms of government transfers such as unemployment benefit.

These forces act as ‘automatic stabilisers’  in that a downturn will increase a government deficit, thus offsetting, at least in part. the decline in private sector spending , a process which the current Minister of Finance has suggested Ireland would allow in the wake of a significant weakening in activity following Brexit (should it happen). A better measure of the fiscal stance, therefore, is to adjust for the economic cycle, an inexact science to say the least but one that is published in the Budget every year by the Department of Finance. A final tweak is to adjust for interest payments on the debt, which are not at the discretion of the  Government ( and are falling rapidly in Ireland’s case ) to arrive at the structural primary balance, which is the preferred measure of the fiscal stance by many economists, including those at the IMF. For example, the 2019  Irish Budget projected a primary surplus of 1.4% of GDP  or 0.8% when adjusted for the economic cycle.

Using that metric, we can see that the 2008 Budget was the last that could be called expansionary , with a planned structural primary surplus of 0.7% of GDP against an expected 2007 surplus of 1.6%. The following budgets saw massive spending and tax cuts, of course but it is surprising and contrary to the perceived narrative that this contractionary process is still at work. For exampe the 2016 Budget saw a projected shift in the adjusted primary balance from zero to a surplus of 0.5% of GDP. In 2017, the projected surplus rose again, from 0.5% to 1.1%, followed in 2018 by a projected 1.3% from an estimated outturn of 0.9%. In 2019 the change in stance was marginal, it has to be said, but nonetheless the projected adjusted primary surplus still rose, to 0.8% from 0.7%, with much larget surpluses projected over the coming years.

These may never materialise , of course, and as noted the implied stance at the delivery of any budget can look very different at the end of the year in question. Moreover, the  above takes no account of what the budgetary position might have been had the suthorities not made the discretionary choices they did, and again it is a common charge in Ireland that  governments have tended to spend  most of  any tax windfalls. One can  therefore debate whether  fiscal policy could and should have been tighter but it is the case that in terms of the actual policy stance as  delivered by the Minister it is over a decade since we have seen an expansionary budget.

 

Ireland’s plunging birth rate and rising unemployment challenges narrative on economy

The CSO has just published two significant data sets , one relating to  the latest demographics and the other to the labour market in the second quarter of the year. The former was broadly as expected,  but the latter came as something of a shock, challenging the recent narrative on the economy.

The Irish population has been growing strongly again after a softer period following the financial crash and that trend continued in the twelve months to April, with a 65,000 increase (1.3%) taking the total to a fresh high of 4.92m. In general, official estimates and projections have tended to underestimate population growth, in large part because of the signifcance and volatility  of migration in the Irish data. In this case  the scale of emigration was largely unchanged from the previous year, at 55,000, but  offset by  substantial immigration of some 89,000, again similar to 2018, to give a net migration figure of 34,000. The latter is now larger than the natural increase ( births – deaths) which has slowed significantly  of late, to 31,000 from 49,000 at the turn of the decade. Indeed, the Irish birth rate ( births per 1,000 population)  although still very high by EU standards is falling rapidly , to 12.4 from 16.6 a decade ago.

Nonetheless, the robust pace of overall population growth allied to the boom in economic activity has resulted in  the emergence of massive capacity constraints across many areas of the economy, most nobaly housing but also in education, health care, public transport and the  infrastructure  around the main cities. The current make-up of that population growth ( a falling birth rate offset by  high net immigration ) makes it particularly difficult to plan for the future, however, as a period of weaker growth in Ireland might have a very significant impact on migration flows and hence total population.

The boom in the economy had propelled employment  to record highs and prompted much discussion about the level of full employment, as the unemployment rate had fallen to a cyle low of 4.5% in June. In that context the other main CSO release, the quartely Labour Force Survey, was a shocker. Headline employment fell marginally in q2  from the previous quarter but normally rises for seasonal reasons and so the adjusted figure saw a 21,000 decline, spread over half of the fourteen industry sectors categorised by the CSO. The labour force continued to rise  in the quarter so the numbers unemployed rose, as did the unemployment rate, to 5.2% from 5.1%. A marginal change in that context but it did result in a much more significant revision to the previously published monthly estimates, as unemployment in July is now 18,000 higher than previously thought and has been rising for the past four months, taking the unemployment rate to 5.3% instead of 4.6%.

Coverage of the data tended to emphasis the annual growth in headline employment, which is still impressive at 40,000 or 2.0%, although this is the slowest annual growth rate since early 2013. The seasonal  adjusted fall in q2 also followed a strong rise of 49,000 in q1 giving a net positive figure over the first half of the year of 28,000, so one might put all this down to a quirk in the data ( which is based on a household survey) particularly as the numbers claiming unemployment  benefit are still falling, albeit at a much reduced pace.

However, confidence surveys have weakened of late and some of the hard data has pointed to slower domestic activity, notably retail sales which fell by a cumulative 6.5% in the three months to July. One obvious culprit behind this caution is Brexit, which may also be impacting the demand side of  the  housing market. Indeed one other surprising feature of the Labour Force data was that construction employment has flatlined for the past nine months, which may be due to a scarcity of labour but also to caution from builders and developers as well.

All in all, food for thought- has unemployment bottomed in this cycle or is this just a short term hiccup which a Brexit resolution  might help to cure? On population, the Irish birth rate may still be the highest in Europe but is heading rapidly towards the EU average which is under 10.

Are estimates of Irish housing demand far too high?

The consensus view on Irish housing is that demand exceeds supply by a considerable margin and that the gap is closing, which many conclude is the key factor in the clear deceleration in residential property price inflation seen over the past year. Yet the increase in supply is not that pronounced and it may well be that demand is not as  substantial as generally believed, particularly into the medium term..

The latest figures on housing completions from the CSO, covering the second quarter of the year, show a half- year total of 9,100  which implies the full year figure will be above the 18,000 recorded in 2018,  albeit pointing to a outturn below 21,000. Supply is therefore still rising but at a sluggish pace, and certainly still a long way from the 30,000-35,000 widely seen as a good estimate of the annual demand over the medium term.

That figure is largely based on projections for household formation but there is an obvious circularity in that households are defined as occupying a house or an apartment. In other words  housing supply creates household formation so  the latter is not an independent estimate of demand. For example, the number of  households in Ireland rose by just 48,000 in the five years to the 2016 census, or by less than 10,000 per annum, but the numbers living in those households increased by 166,000, indicating a rise in the average household size. Housing demand projections  generally assume that the size of households will fall over the medium term.

So household formation averaging 30,000 or more a year implicitly assumes  housing supply around that figure , and lower supply would mean lower household formation. A look at the latest population projections by the CSO also gives food for thought. On the assumption of unchanged fertility and an annual net migrant inflow of 30,000 per year the population between 25 and 44 increases by just 8,000 in total by 2025, with the numbers between 30 and 40 years old declining sharply. If migration was much lower, at 10,000 per annum, and fertility declined, the CSO projection shows a 100,000 fall in the 25-44 age group which is the cohort one generally associates with house purchase and household formation.

If supply is the main determinant of demand  the recent data on planning permissions, showing a fall in the annual figure to below 29,000, casts doubt on whether supply will exceed 30,000 a year and , if so , household formation will be much lower than the received wisdom. The average number per household may in fact continue to rise .

 

The strange improvement in Irish mortgage affordability

The Irish housing market has developed a number of unusual features of  late , one being the trend in mortgage affordability. That concept  captures the monthly payment on a new mortgage relative to the borrowers income and will generally deteriorate as the housing cycle unfolds; rising house prices  will push up the average size of a new mortgage and more often than not interest rates will also increase, offsetting the positive impact of rising incomes. For example. the average new mortgage for house purchase in 2008 was €270,000 against €172,000 in 2004 , with the  mortgage rate rising to 5.1% from 3.4%. As a result the monthly payment for a new borrower almost doubled, from €850 to €1600, dwarfing the rise in income over the period.

One big difference in the current cycle is that mortgage rates have not risen, and indeed  have actually fallen a little since the cycle turned in 2013; the new mortgage rate was  3.0% last year versus 3.25% five years  earlier and if anything is likely to be marginally lower still in 2019. Against that, rising house prices have pushed up the average new mortgage and affordability deteriorated from 2012 to 2017, albeit at a modest pace and still leaving the monthly payment relative to income below the long run average.

Another difference in this cycle is the controls on  mortgage leverage brought in by the Central Bank in 2015, including a  3.5 LTI limit. 20% of lending to FTB’s is allowed to exceed the limit but one might expect that the average new mortgage would now be tied more closely to average incomes in the economy, but what is curious is that the the growth in the average new mortgage for house purchase is now lagging the growth in incomes, so on the face of it affordability is improving again.

In 2018 household disposable income rose by 6.2%, but the average new mortgage for house purchase rose by only 4%, to €226,000. Employment growth and wage inflation have both acclerated in 2019 and according to the CSO household incomes rose by over 8% in the first quarter, so it seems likely that the full year will see another  very strong rise in incomes. Yet data on mortgage drawdowns from the BPFI show that the average new mortgage  for house purchase over the first half of the year was €230,6000 and just 2.5% up on the same period in 2018, so again substantially lagging income growth.Of course mortgages in Dublin and the surrounding counties will be higher, and affordability correspondingly worse, but it remains a puzzle as to why the national picture shows a booming economy and yet very limited growth in the average new  mortgage. In fact it is hard to explain the recent slowdown in house price inflation in fundamental terms, given the affordability improvement and the relatively slow increase in housing supply, which is still far short of what is generally deemed to be required. Price  expectations from both buyers and builders may be the most significant factor.

 

 

Strong growth in first quarter following large upward revision to 2018 GDP

The Irish economy, as measued by real GDP, is now deemed to have grown by 8.2% in 2018, as against the initial 6.7% estimate. Growth in 2017 was also revised up, by around 1% to 8.1%, according to the latest National Accounts. The most interesting change came in the personal consumption component, which had seemed puzzlingly soft given the buoyancy of household income. It now transpires that consumption last year was  €107bn, or €3bn higher than the initial estimate, and real  consumption growth over the past three  years is now put at 12% instead of 8.8%, Government consumption growth, in contrast, was revised down and is now 2% lower than initially recorded over the past three years, albeit still at a robust 11.9%.

GDP in 2018 is now put at €324bn, some €6bn higher than the initial estimate, which means that the General Government debt ratio is now about one percentage point lower at 63.6%. The CSO also produced the first estimate of modified national incomein 2018, which some prefer to use as the debt denominator, and this came in at €197bn giving a ratio of  104.4%, down from 109.5% in 2017.

Turning to 2019, recent higher frequency data , notably employment and industrial production,  had implied strong GDP growth in the first quarter  and that duly emerged, at 2.4%. Exports and personal consumption both grew by around 1%, with government consumption expanding by 0.5%. A strong stock build was also evident but these positives were offset by a 25% plunge in  capital formation,  reflecting similar falls in both spending on machinery and equipment and Intangibles. The latter is largely due to multinational activity and is also captured in the national accounts as a service import, so is GDP neutral (imports fell by 2.8%) but of more significance was the underlying decline in machinery and equipment spending when adjusted for aircraft leasing, meaning that modifed capital formation ( designed to better capture domestic investment) actually fell by 2.4%.

The first quarter advance  boosted the annual growth rate  of GDP to  6.3% and the  consensus for the full year is under 4% (our own estimate is 5%). However, analysts may in general hold fire on any material changes to forecasts given the evident weakness  over recent months in the UK and EA economies, alongside softer growth in the US. Brexit remains the biggest specific risk, of course, and the fall in domestic business investment may well reflect the uncertainty about  the shape  and timing of an eventual resolution.

ECB rate cuts and Tiering

The current 3-month euribor rate is -0.32% and the market is now firmly expecting lower  ECB rates in the near term, with a 10bp cut priced in over the next few months and a return to a positive figure not expected till the end of 2023. A combination of weaker economic data (Germany may well have contracted in the second quarter), a fall back in inflation and more dovish rhetoric from Draghi and others has convinced the market that further monetary easing is  now highly likely, as opposed to the prospect of the modest tightening signalled by the Governing Council last year.

Market measures of  Euro Area (EA) inflation expectations have also plunged , raising doubts as to whether investors have much faith in the ECB’s ability to push inflation up to the target, and a new research paper from the Bank admitted that their standard models cannot explain why inflation has undershot their forecasts of late. Nonetheless the Governing Council insists that it still has the policy instruments required. A resumption of QE is possible but the market focus has been on  rate cuts, as that would also put downward pressure on the currency,

Which rate to cut?  The refi rate is currently zero so a reduction there would take it into negative territory and would certainly have an impact in Ireland- about 40% of existing mortage holders here are on tracker rates , averaging around 1%, so they would immediately benefit. However the ECB’s deposit rate, at -0.4%, is more important in driving money market rates and a cut is more likely to emerge there. Banks in the EA have to hold reserves, determined largely by the volume of customer deposits held, but for a long time now Banks across the zone have held a massive amount of excess liquidity which in the aggregate now amounts to around €1,900bn and puts downward pressure on money market rates. The ECB’s deposit rate acts as an effective floor, therefore, and a cut would lead to lower money market rates.

So a deposit rate cut of itself would not benefit Irish Tracker mortgage holders but would probably result in a fresh round of lower fixed rate mortgage offers and  a cut in existing standard variable rates. The ECB’s negative deposit rate has other consequences however, notably in terms of dampening the profitability of EA banks. This may not be a narrative that sits well in Ireland but the Governing Council appears to have become more concerned about the potential negative  impact on bank lending from the squeeze on net interest margins .

In fact the other countries that have introduced negative policy rates ( Japan, Switzerland, Denmark and Sweden)  have also included mechanisms to mitigate the adverse impact on commercial banks, essentially by allowing far more reserves to be remunerated at  a rate well above the deposit rate, a process known as Tiering. So for example, the ECB might allow  banks to hold a multiple of their reserve requirements, say  15 or 20 times, at the main refinancing rate  and so reduce the sums being  held at the (lower) deposit rate . Of course, the trick would be to still leave enough excess liquidity to drive money market rates lower and hence ease policy. Tiering would also persuade markets that rates could be lower for longer given that the potential damage to banks has been reduced.

The EA is different from the other countries noted above, however,in that excess liquidity is not evenly distributed across the EA. In fact most is held by banks in Germany, France and the Netherlands, with little held in the periphery, including Ireland. So Tiering would certainly boost the profits of core banks but may not have much impact on banks elsewhere, again including Ireland, Indeed, if banks can now hold far more reserves at a zero rate of interest it may prompt  some selling of government bonds currently paying a negative yield as this now becomes more painful. One size  certainly does not fit all  given the fragmentation of monetary policy across the EA  which  complicates the ECB’s task and no doubt explains why they are still ruminating on Tiering and how it might best work in the euro zone.

Has the ECB run out of monetary road?

Survey data has pointed to weaker global activity for some time now, notably in manufacturing, but the hard data surprised to the upside in the first quarter, with world growth an anualised 3.3% from 2.75% in the final quarter of 2018. Markets are  increasingly nervous , however, fearing that the deterioration in US/China relations will have a much more serious impact on global trade than seen to date. The flight from risk has seen chunky falls in equity and commodity markets while the 10-year German bond yield is trading at -20bp, with the corresponding yield on US Treasuries falling from 3% to 2.10%.

Part of that latter decline can be attributed to a substantial change in  expectations about monetary policy, with the futures market currently priced for a Fed Funds rate of 1.85% by year-end, from the current 2.40%. US growth appears to have slowed in the second quarter (the Atlanta Fed model is tracking an annualised 1.2%  from over 3% in q1)) but to date there is little to suggest that the States is slowing sharply enough to warrant that kind of easing. That could change, of course,  and some at the Fed are already concerned about inflation being a little low particularly given the strength of the labour market.The FOMC also appears to be giving more weight to global factors in its policy deliberations, despite the fact that the US is a relatively closed economy in terms of external trade, and to financial conditions, notably the stock market.

The Fed had already announced that it will stop reducing the size of its balance sheet and  clearly has some room  to cut short term rates, which contrasts with the ECB, as the latter has not been able to tighten policy despite a prolonged recovery in economic activity in the Euro area, and  facing into a possible downturn with  a zero refinancing rate and a negative deposit rate.

The Governing Council in Frankfurt was confident last year that the tightening labour market would push up wage inflation and ultimately price inflation but has been forced to consistenly revise down  forecasts of core inflation. Consequently, the first suggestion of  monetary tightening, based on forward guidance signalling a likely  rate rise around September this year, was  then modified to the end of 2019 but that too looks redundant given that market rates now  only imply a 10bp rate rise from current levels in early 2022. Indeed market rates are now priced to go modestly lower still over the next year.

The failure of the ECB’s various policy tools to generate underlying inflation anywhere near  target prompts the obvious question as to what the Governing Council can do now, particularly if growth slows sharply. Another round of cheap long term loans to banks is likely and forward guidance will no doubt be extended but banks are awash with liquidity as it stands, while the negative deposit rate is hurting bank profits, a fact acknowledged of late by the ECB, as well as sending a signal to the population at large that we are still in an economic crisis, despite tha fact that unemployment across the zone has just fallen to levels last seen in 2008. Another round of asset purchases is also a possibility, although that may face tricky issues around the Capital key and the Bank’s already high ownership share of some  government bond markets.

The  broader debate about whether monetary policy can be effective at or near the lower bound in rates, alongside scepticism about the impact of QE on consumer prices (as opposed to asset prices) has prompted renewed interest in fiscal policy , having fallen out of favour in mainstram economic thinking over recent decades.

Some economists now argue that the low rate environment changes the cost/ benefit equation in favour of expansionary fiscal policy. The case is that in many countries the average interest rate on the debt is now below the growth rate of GDP, so on standard debt dynamics a government could run a primary deficit and still put downward pressure on the debt ratio, A more radical strand, based on Modern Monetary Theory, argues that for any country with full monetary sovereignty ( i.e. it can print its own money)  a debt default can only occur as a policy choice and that there is no great reason why such countries should not run budger deficits to boost employment or to achieve  other socially useful goals, paid for by printing the money rather than through higher taxes or issuing bonds.

The latter approach has many mainstream critics but is not applicable anyway in  the euro zone ( no member state can print euros)  while the ECB will no doubt argue it has not run out of policy options. One  radical approach discussed in academic circles is for Central Banks to adopt a more flexible inflation target or even a range and Draghi himself has stated that the ECB’s inflation target is not a short term ceiling, implying a tolerance for above target inflation for a while. This emphasis on expectations in determining inflation perhaps puts too much weight on that component and low inflation may owe far more to structural factors such a globalisation, free trade (to date at least ) and a much lower  equilibrium real rate of interest, so rendering a 2% inflation target as unachievable anyway, let alone a higher inflation rate.

In fact fiscal policy in the euro area is already set to be a litle more expansionary this year anyway, but in the event of an outright recession we are likely to see much more aggresive fiscal expansion across the zone, albeit without a public acknowledgement that policy makers in the EA erred in recent years in making monetary policy, and hence the ECB, the only player in town.

Irish rental yields imply dysfunctional housing market.

House price inflation in Ireland has slowed of late, easing to 5.6% in January from more than double that pace a year earlier. The deceleration largely reflects the trend in Dublin, with prices in the capital falling by 2.8% in the three months to January, so reducing the annual increase to just 1.9%, while the CSO’s index for the rest of the country shows prices still rising strongly, by an annual 9.5%. The supply of new housing has picked up but is generally perceived to be well short of demand, so the softer tone in Dublin may reflect issues on the demand side, such as uncertainty over Brexit, affordability and the impact of the Central Bank’s mortgage controls, which limit leverage .

On the rental side the asking quote for new lets on Daft.ie. is  still rising strongly (  an annual 9.7% increase  in the final quarter of 2018) while the annual increase in rents actually paid in q4 was 6.6% as captured in the CPI or 6.9% as measured by the Residential Tenancies Board (RTB). Yet that mix of rents and house prices does not make much sense as the implied rental yield seems extraordinarily high.

According to the RTB the average monthly  rent in Ireland in q4 was €1134 and from the CSO database the average price of residential property ( as sold in the market)  was €290,800 over the second half of 2018, giving an implied yield of 4.7%. Similarly, the average  Dublin rent of €1650 implies a similar yield in the capital, while using median as opposed to mean prices pushes both yields up to 5.5%. The Sunday Times recently quoted a transaction  involving an Irish Reit with an implied  residential yield even higher, at 6.7%.

From an investment perspective a standard approach to valuation is to compare the yield on a given asset to the risk free rate, generally proxied by the 10-year government bond yield, and one would expect rental yields to be higher given a risk premium. That is indeed the case with an average differential of around 0.3% going back to the 1990’s. Yet the Irish 10-year bond yield has spent over three years below 1% and is currently trading at 0.6% so implyimg ‘excess’ returns on property of over 4% a year.

The relationship between the average mortgage rate and rental yields can also be revealing. Yields fell to 3% and below in the run up to the housing crash and as such well below the prevailing mortgage rate , but that is far from the current situation, with the latter  around 3%.

So rental yields look high relative to the cost of borrowing and the yield on alternative assets, and in a well-functioning market competitive forces might be expected to  push yields down, either through lower rents or higher prices. In fact yields have declined over thee past six years but only modestly, and that was due to  a 75% rise in prices outpacing a 60% rise in rents. Absent a big demand shock to employment the most likely driver of any moderation in rents is an increase in rental supply, which is on the cards, but that is a slow process. Moreover, rental controls benefit current tenants but at the margin may discourage rental supply, Similarly, mortgage controls will help to prevent a credit bubble but will also dampen housing supply as well as keeping potential buyers in the rental sector for a longer period.