Irish economy grew by 6.7% in 2018 but slowed sharply in final quarter.

The Irish economy, as measured by real GDP, grew by 6.7% in 2018 following a 7.2% rise the previous year. The outcome was marginally ahead of our 6.5% estimate but below consensus, with many expecting a figure around 7.5%. Nominal GDP grew by  8.3% and is now €318bn , or €150bn (88%) above the pre-crash level, which flatters ratios using GDP as the deflator, such as the debt ratio, which fell to below 65% in 2018 from a peak of 120% in 2012.

That surge in GDP  largely reflects the growth of investment and exports, and it is striking that personal consumption now only accounts for one-third of Irish GDP, indicating that it has far less influence on economic growth than the norm elsewhere. Consumption, as recorded in the national accounts, has also been surprisingly modest given the strong rise in household income seen in recent years;  the former grew by  4.4% last year or 3% excluding price changes, which implies a significant increase in the savings ratio given that household disposable income probably rose  by at least 5.5%.

In fact government consumption has outpaced personal consumption for the past three years, with a very strong real rise of 6.4% in 2018 bringing the  volume increase since 2015 to  14.5%.Clearly the government has taken the opportunity afforded by better than expected tax receipts, largely from corporation tax, to increase current  as well as capital spending at a robust pace.

Building and construction has been expanding strongly since 2013 and the rise in 2018 was 15.9%, similar to the previous year, with housebuilding up 26%, although the pace of growth is slowing, as one might expect given the low base for house completions post-crash and subsequent high growth rates in percentage terms.

Spending on machinery and equipment tends to be volatile in general but in Ireland’s case is strongly affected by the purchase of aircraft, with the latter particularly strong last year, contributing to a 37% increase. The other component of capital spending is Intangibles, covering R&D, and this fell, by over 10%, albeit recovering strongly in the second half of the year. The net result was that total capital formation rose by 10% in 2018 after slumping by over 30% the previous year.

Virtually all of the Intangibles spending is also recorded as a service import and total imports grew by 7% in real terms last year, albeit outpaced by an 8.9% increase in exports. giving a positive contribution from the external sector. Indeed, the current account surplus on the balance of payments rose to €29bn  or 9.1% of GDP from €25bn in 2017.

Looking at the quarterly data, a marked deceleration through the year is apparent,  with the annual growth rate slowing from 9.6% in the first quarter to 3% in q4,  the latter implying a softer carry-over into 2019 than many had expected.The slowdown was particularly evident in consumer spending and construction. In fact the quarterly change in GDP in Q4 was just 0.1% and modified domestic demand (which seeks to strip out multinational investment spending) actually fell marginally.  It is also noteworthy that unemployment actually ticked  higher in the final months of 2018 and that house prices fell in three consecutive months to January. Brexit uncertainty is no doubt a factor but it may be that the economy is approaching  or even at full employment and hence supply contrained as well as suffering from a short period of softer demand.

ECB’s negative rates trap

June this year will mark the fifth anniversary of the ECB’s decision to cut its Deposit rate into negative territory, with three subsequent moves  taking it to the curent -0.4%. That, alongside excess liquidity of some €1,800bn, means that it is the deposit rate and not the  zero refinancing rate which drives short term money market rates, and these have also been negative for years now.

Three other European Central Banks have negative policy rates -Denmark, Sweden and Switzerland- as well as the Bank of Japan , while both the Federal Reserve and the Bank of England chose to cut rates to very low but nonetheless  positive levels.

In theory, low interest rates are expected to boost economic activity and inflation by encouraging households to borrow and spend instead of saving, and to boost  capital investment by the business sector. Low rates relative to other economies may also lead to a currency depreciation, which , again in theory, is thought to boost exports and hence economic growth. Negative rates are therefore  merely an extension of lower rates, it is argued. Such  rates in the EA have certainly helped to lower the cost of funds for the banking sector, as often pointed out by the ECB, but one would have to conclude that the net effect has been disappointing; monetary growth has been limp, the growth in bank lending to the private sector has been modest ( annual growth slowed to 3% in January)  and core inflation has remained stubbornly anchored around 1%.

It is also apparent that negative rates have had negative consequences. It has been evident for some time from the ECB’s Bank Lending surveys that most banks report pressure on net  interest margins, given that rates payable by borrowers have fallen, as has the yield on bonds held by banks (many of which are also negative), but that zero is the effective lower bound for rates payable to retail depositors. Higher loan volumes might offer an offset but, as noted, credit growth across the zone has been tepid and very weak in some countries (Irish mortgage growth only turned positive in 2018 ). The knock-on effect is that European banks are generally trading well below book value , in contrast to their US peers, which may not be a concern to many but is of  concern to the ECB as it fears the consequences for future credit growth.

Negative rates are also a crisis measure, by definition,  and that signal is probably encouraging households to save more rather than less, despite or even because of the meagre returns, Similarly, it is the prospect of return rather than the cost of borrowing which drives business investment, so negative rates may well dampen the former because the of the message on the economic outlook they send.

When will rates turn positive? Last year the ECB grew increasingly confident that underlying inflation in the EA was picking up, helped by stronger wage growth, and  duly signalled that the first upward move in rates would occur from around September 2019. That forward guidance remains in place but the market is now only fully priced for a 10bp  increase in the Deposit rate in the summer of 2020, given  the recent weak data and the lack of any upward move in core inflation. The rhetoric from the ECB’s Governing Council has now changed and it would not be a surprise if the forward guidance was tweaked at the upcoming  policy meeting.

Market expectations change, of course, moving with the flow of data, but for the moment 3-month rates are not expected to turn positive  until the summer of 2021. The ECB may therefore be stuck in a rate trap, in that rates will only turn positive in response to a material pick up in core inflation, but that outcome is rendered less likely by negative rates.