Bit early to blame Central Bank for house price fall

The CSO’s  residential property index   for February showed a fall in Dublin prices for the second month in a row, the 0.7% decline bringing the fall over three months to 2.4%. This still left the annual rise at over 21% but the market in the capital has clearly lost some momentum over recent months and some have claimed that the Central Bank’s new macro-prudential controls on mortgage lending are responsible. Prices excluding Dublin were flat in February but also fell on a three month basis, albeit by only 0.3%, so adding to the perception that there is a common factor at work across the country.

The evidence is not persuasive, however, at least not yet. The rules only came into operation in late January , for a start, and there does not appear to have been a significant shift in the recent pattern of mortgage approvals ahead of the decision. Mortgage approvals in the three months to January rose by an annual 55,5%, and as such not materially different from the 56.5% in the three months to December. Housing transactions in January were actually very strong, according to the Property Price Register(PPR), rising by an annual 68% . The available February data does show a marked deceleration in the pace of annual growth in transactions, to 35%, but that figure may be quite different when all the filings are included, which does take time.

The Central Bank’s own research (1) also suggests that the mortgage limits on Loan to Value and Loan to Income will have little impact on prices but a more significant  effect on mortgage lending and on the supply of housing, which they suggest will be some 2-3% lower per annum for a number of years ,resulting in a loss of some  2000  units  after 4 years relative  to an unchanged policy forecast. That  reduction in supply will put upward pressure on prices , so dampening any downward effect from tighter credit standards.

Any such simulation depends on the housing model used of course, and the ESRI (2) has just come out with some findings of its own. These also point to a significant effect from the new mortgage rules on house completions, with a supply fall of some 4%-5%, although they predict a larger effect than the Central Bank on prices, albeit  still a modest 4%-5%.

Another problem inherent in linking recent price trends in residential property to the Central Bank regulations is that not all housing is behaving the same way. Apartment prices nationally rose by 1.9% in February and by 2.5% on a three-month basis. Apartments in the capital also rose strongly on the month, by 2%, and by 1.8% over three months. The price series on apartments is extremely volatile but apartment prices in Dublin have now risen faster than houses over the past year (by 24.5% versus 21.1%).

Perhaps a better explanation for the most recent slowdown in house prices is simply that a market which appears to be primarily  driven by cash buyers is likely to lose momentum. That’s not to suggest that prices are likely to fall sharply but that annual house price growth in excess of 20% is unlikely to be repeated for long in the absence of excessive credit growth. New mortgage lending is picking up , and showing very strong percentage growth given the low base, but it is still accounting for less than 50% of housing transactions. Indeed, the latest PPR figures show transactions of over 15,600 in the final quarter of 2014, with the number of new mortgages drawn down for house purchase amounting to less than 7,000 , or 44% of the total.

(1) ‘Assessing the Impact of macro-prudential measures’ Central Bank of Ireland, Economic Letters , Vol. 2015, No.3

(2) ‘Quarterly Economic Commentary’, Spring 2015, ESRI

Irish Domestic Demand rises in 2014 after 6-year decline

The Irish economy grew by 4.8% in real terms in 2014 according to preliminary data from the CSO, which was marginally below the consensus estimate, albeit slightly better than anticipated by the  Government. Nominal GDP expanded by 6.2% , taking it to €185.4bn, again slightly above the official estimate, which reduces the previously published debt  ratio for 2014  by around 1 percentage point , while not affecting the deficit ratio.

The Irish economy bottomed as far back as the final quarter of 2009 but  domestic demand has remained weak and in that context perhaps the most significant aspect of the 2014 data was the first rise in domestic spending in seven years; final domestic demand ( the sum of personal consumption, government consumption and investment expenditure) rose by a very healthy 2.9%. Government spending was flat ( the puzzling rise evident earlier in the year was revised away) and investment grew strongly, by over 11%, in part due to further growth in building and construction. Personal consumption also rose,  but by a modest 1.1%, which was  well below most forecasts  made last year. It is  certainly the case that the national accounts estimate is low relative to the recent trend in retail sales but in general it would seem that deleveraging has proven a very significant drag on household spending, partially offsetting  the positive effects of rising employment and falling prices. The net effect is that consumer spending now accounts for 45.6% of Irish real GDP, the lowest share in a decade. That said , consumption did rise strongly in the final quarter of 2014 , and with wages now picking up,  2015 may see household spending gain some momentum.

Net exports continued to provide the main impetus to Irish GDP last year, although the growth of external trade was massively stronger than anyone has initially anticipated, partly due to a rebound in chemical exports  and partly to methodological changes to the Balance of Payments (BOP) ; the volume of exports rose by 12.6% with imports up by 13.2% (the former have a much higher weight in GDP so net exports still made a positive contribution). As a result  Ireland’s current account surplus on the BOP rose to a record €11.5bn or 6.2% of GDP. The implication is that Ireland is now generating substantial excess savings, with the private sector surplus more than offsetting the public sector deficit, which of course it needs to do in order to repay external debt.

On a quarterly basis the national accounts  revealed a pronounced slowdown through the year, with GDP expanding by a seasonally adjusted 3.5% in the first half ( revised down from an initial 3.9%) and by just 0.6% in the second, with the final quarter recording a very modest 0.2%. Domestic demand  slowed in H2 , despite a 1.3% increase in consumer spending in the final quarter, and imports outpaced exports, although again the new BOP format had an impact, boosting merchandise exports but also increasing service imports. The respective growth rates of the two  have been spectacular as a result; the latter ended the year with annual growth of 22%, and the former at 27%.

Eternal trade has therefore ended the year at much higher levels that anyone initially envisaged  and adds a further degree of uncertainty to  GDP forecasts for 2015, particularly as the monthly merchandise trade data now gives little clue to the total external trade position. That aside, the headline outturn is unlikely to prompt any major revisions to the existing consensus ( around 3.8%) and the main positive is that domestic demand is growing again, with some signs that consumer spending is finally  beginning to pick up.

The Fed, Policy Rules and Market rates

It is a long time since the US Federal Reserve last raised rates ( in June 2006, from 5% to 5.25%)  and one has to go back over a decade to find the start of a tightening cycle (in June 2004, from 1% to 1.25%).Consequently there are many in the financial markets who have never  experienced a period of rising interest rates although that may be about to change, judging by rate expectations; the Fed Funds rate is currently trading at 0.12% ( the Fed’s target is 0-0.25%)  and the futures market is pricing in a strong probability of a rate rise over the late-summer and autumn this year.

Of course the Fed itself has also changed tack in terms of monetary policy, in response to the improvement in the real economy, including strong employment growth and a decline in the unemployment rate. Consequently the FOMC terminated its asset purchase programme last year and has now dropped its forward guidance on rates, indicating that the decision will now be data dependent. That does not mean that a rate rise is inevitable ( some FOMC members are worried that inflation is low and may not pick up as anticipated)  and the exact timing is clearly debateable, but what is interesting is the divergence between the market’s rate expecations over the next few years and that indicated by the published views of the FOMC.

One standard method of predicting the future path of Fed policy is using the Taylor rule, first put forward in 1993. The original  formulation  envisaged an equilibrium Fed funds rate of 4%, with the Fed adjusting policy if growth moved away from trend or if inflation deviated from target (assumed to be 2%). A popular variant of the model uses an empirical relationship between unemployment and economic growth (Okun’s law) to derive a rule which includes the unemployment rate  as a proxy for full employment instead of GDP or

r = 1 + 1.5PCE – (UR -URF)

where r= the Fed funds rate, PCE is the annual inflation rate ( the Fed prefers the consumption deflator to the CPI) , UR is the unemployment rate and URF is the rate associated with full employment

We can use such a model to project the Feds fund rate implied by the latest forecast made by the FOMC members(based on the  central tendency). That envisages the unemployment rate falling to 5.25% by the fourth quarter of 2015, and as such around the Fed’s idea of full employment ( an unemployment rate between 5.2% and 5.5%). The FOMC expects inflation ( at 1.3%) to remain below target this year but to  move up to just under 2% by 2017, and based on those forecasts the Taylor rule implies a Fed funds rate of 2.9% at end-15, 3.9% at end-16 and 4% in 2017.

Indeed, the rule indicates that Fed policy should have been much tighter at the end of last year ( around 2%) . The severity of the Great Recession and the sluggish nature of the economy have persuaded central bankers that this time is different, however, and Janet Yellen, in a speech in June 2012 *  put forward reasons why policy should remain looser for longer and discussed two alternatives to the Taylor rule as outlined above.

The first , a Balanced rule, doubled the weight on the unemployment variable. This did imply a different rate trajectory given the level of unemployment at that time but such a model now shows little difference from the basic Taylor rule, because  the unemployment rate  is so close to full employment- the  path of  the Fed funds rate is virtually identical in the two models.

Yellen went on the put forward a third approach – optimal control. This involves using a range of Fed funds rate in a model of the US economy  in order to minimize a loss function, with the latter set in terms of the deviation of unemployment and inflation from target levels. That approach did imply a longer period of zero rates and a slower tightening cycle, albeit  also rising to around 4% in the medium term. We do not know what that optimal control approach states now but based on the charts published in the Yellen  paper  it may imply a Fed funds rate of 1.25% by end-15 and 3% by end-16.

The Fed will not slavishly follow any model in setting policy and the data may disappoint but what is striking is the divergence between market rates and that implied by any of the three models if the fed ‘s economic forecasts are broadly right. For example, 3- year bond yields are currently trading at 1% with the 2-year at 0.63%, which implies a 1-year rate in two years time of 1.7%. If the market is wrong in its implied pessimism on inflation and growth  there is a very big bond market accident waiting to happen.

* Yellen, ‘Perspectives on Monetary Policy’ , Federal Reserve, June 2012