Next Government may have €2.5bn more to play with

A new Irish Government has yet to be formed post-election but EU fiscal rules have not gone away and to that end the Department of Finance has just published its annual Stability Programme Update (SPU) which has to be submitted to the European Commission  by the end of April. The SPU sets out medium term fiscal and debt projections based on updated economic forecasts. The publication would also normally provide a detailed breakdown of the monies available to the government of the day given the constraints imposed by Brussels in order for Ireland to comply with the Stability and Growth Pact. However, in this case, there is no detailed breakdown of the ‘Fiscal Space’ available to the incoming administration, although it is possible to arrive at some broad conclusions given other published information. On that basis it seems there may be more Space available than previously envisaged, as much as  €0.5bn annually over the next five years.

Irish GDP growth emerged at 7.8% in 2015, well above any earlier forecasts, which has prompted a rise in the consensus estimate for the current year. Consequently it is not a surprise that the SPU has also revised up the official  growth forecast for 2016, to 4.9%, from the initial 4.3% underpinning the  Budget. That has not resulted in any change to forecast tax receipts, although other minor revisions mean that the General Government deficit is now expected to be marginally lower that previously projected, at 1.1% of GDP instead of 1.2%.

The EU rules impose limits on the growth of government expenditure (net of certain adjustments like unemployment benefits, debt interest and capital spending) with that limit depending on  the economy’s potential growth rate averaged over a decade. A key development in the SPU  is that Ireland’s potential growth of late is now estimated to be much higher than previously thought. In 2015, for example, potential growth was estimated at 3.4% but is now put at 4.4%, with a figure of 5% now seen for both 2016 and 2017. In addition , Irish Government expenditure  in 2015 has been revised up by €1.5bn (reflecting a reclassification of State transactions with AIB ) which therefore raises the expenditure  benchmark. These two changes mean that spending can now rise by  a greater amount while still complying with the fiscal rules.

In the 2016 Budget, for example, the Government was limited to a €1.2bn increase in spending (net of any tax change) and this Fiscal Space was fully realized. It now appears that the figure could have been higher, perhaps €1.7bn.  In 2017, the gross Fiscal Space  available was estimated  at €1.3bn but  may well be above that given these new figures, at €1.7bn or €0.9bn  in net terms when allowing for  known demographic pressures on spending  and  other existing  expenditure commitments. This net Fiscal Space figure compares with the €0.5bn previously published.

Further out in time, the higher GDP growth figure will boost the Fiscal Space , as will the EU decision to allow Ireland to aim for a small budget deficit (0.5% of GDP) rather than the budget balance target previously agreed. The  result is that the  net Fiscal Space available over the five years from 2017 to 2021 may be around €11bn , rather than the €8.5bn previously published by Finance. How those resources are allocated will be up to the new government, although one should note that they make no allowance for any broad based increases in public sector pay and may underestimate the pressures on the Health budget.  Of course the government also has the option to eliminate the deficit completely and to run down  the national debt at a faster clip, by choosing not to utilize all the available Fiscal Space, but that appears unlikely given the present political backdrop.


Negative Deposit rate hitting profitability of euro banks.

The ECB first cut its deposit rate to negative territory in June 2014, to -0.1%, and reduced it again late that year, to -0.2%, with a third cut taking it to -0.3% in December 2015. A further reduction was announced last month, to -0.4%, and since then criticism of the move has intensified, most notably of late from the German Finance Minister, concerned at the low return for savers.  Low and negative bond yields are putting pressure on insurance companies with products offering a guaranteed return and  the ECB’s deposit rate is particularly irksome for  the hundreds of small savings banks across the Federal Republic, given that retail deposit rates cannot fall below zero.

That squeeze on margins is not an exclusive German phenomenon, of course, and any banking system with a high dependency on retail deposits will be affected. Ironically, perhaps, banks in general have been urged to reduce their dependence on  the wholesale markets , and new Basel III rules on liquidity and funding also push banks towards deposits.

The ECB has recently responded to the criticism  by arguing that any squeeze on net interest margin  can be more than offset by higher loan growth, which the policy is designed to stimulate, and the capital gains resulting from the fall in bond yields. In that context the results of the latest  ECB Bank Lending Survey (BLS) for April is instructive, as it includes a number of ad hoc questions regarding the impact of non-standard monetary policy, including the effect of  the  negative  deposit rate. Not one  bank felt the deposit rate had a positive impact on their net interest income, with 63% stating a negative impact and another 18% a very negative effect, giving a net negative figure of 81%. Asked about the next six months, the net negative figure climbed to 85%. The vast majority of banks had seen no impact on loan volumes, although there was a small net positive, but this was offset by the negative impact on margins, so reducing overall income.

The survey also asked respondents about the impact of the ECB’s asset purchase programme, and again the results are unlikely to raise too much cheer in Frankfurt. A  small net number of banks (4%) had sold sovereign bonds as a result of QE and those experiencing capital gains in general  on assets for sales was a net positive 12% but that benefit was also more than offset by the net interest margin impact, with a net 27% seeing a fall in NIM. The result was that only 9% of banks had seen profitability rise as a result of QE, with 28% experiencing a profit fall, leaving a net decline percentage of 19%.

On the positive side QE was seen to have  improved the liquidity position of banks and  access to financing, notably via covered bonds, and the ECB has of late highlighted these metrics as a sign that  non-standard measures are working. Credit to the private sector is also finally growing again, albeit by an annual 0.9% , but for the moment at least the evidence supports the view that negative rates, in particular, are having a detrimental  effect on bank profits. It remains to be seen how that will change when the ECB’s long term loan scheme comes on stream.




Fed Hard to Fathom

In December last year the US Federal Reserve tightened monetary policy, albeit by only a quarter point, citing the ‘considerable improvement in labour market conditions’ and an expectation that inflation would gradually recover to the desired 2% level. The accompanying statement emphasised that further rate increases would be gradual, although the projections released at the time from the 17 FOMC participants (the ‘dot plot’) indicated a median expectation  that 2016 would see four further quarter point rises.

The market was not convinced but the latest ‘dot plot’ , released in mid-March, was still a surprise to many, as the median expectation now showed only two rate increase by year-end. True, growth was now projected to be marginally weaker in 2016 and 2017 but the unemployment rate was also forecast to be  lower, falling to 4.5%, against  4.8% in the long run. Inflation ( the Fed’s measure is the personal consumption deflator)  was expected to end the year at 1.2%, down from the previous 1.6% forecast, but the core rate forecast  (defined as ex food and energy) was unchanged at 1.6%.

Monetary policy is deemed to have ‘long and variable lags’ so one might think that unemployment around the Fed’s desired level alongside an expectation that inflation will pick up would be consistent with steady rate increases. let alone a change to a more dovish rate outlook. Core inflation has actually  picked up of late , rising at an annual 2% rate over the past three months, and the annual rate is 1.7%, which is above the Fed’s expectation for the year-end. Yet Janet Yellen, in a recent speech, emphasised that low inflation expectations were now a concern. Survey measures had shown a fall while market based measures had also declined ; the 10-year break-even inflation rate fell to 1.2% in February. She highlighted the risk that lower expectations would feed into wage and price setting, so increasing the probability of inflation remaining below target for longer. The Fed Chair also flagged the possibility that  the unemployment rate could fall much further without triggering wage inflation and  also pointed to international risks to the US economy.

So it is now very difficult to see what would trigger a rate rise in the coming months. A further improvement in the labour market does not seem a sufficient condition and higher spot inflation may not be sufficient either, given the emphasis put on inflation expectations. In fact the latter is heavily influenced by spot inflation anyway, particularly high frequency purchases like fuel, and  market expectations have actually risen again of late, perhaps driven by the rebound in oil prices in March.  Crude prices have  fallen back again in the past week, however, and this may dampen expectations again.

The Fed funds future for December is trading at 0.5%, so the market is no longer convinced we will see any rate increase this year. Central banks generally tread a line between Discretion on policy or following a more Rules based approach and the former is driving the Fed at the moment, which makes for flexibility but makes it very hard to read their next move.