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.

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.

Has Irish Unemployment hit its cycle low?

During the Celtic Tiger years the Irish unemployment rate was consistently below 5% and most forecasters envisage a return to  that position in 2019. The monthly data had put the January figure at 5.3% and although the pace of decline had slowed it seemed reasonable to assume that the strength of job creation would be sufficient to  again  push the unemployment rate below 5%, before hitting full employment.

That view  is now open to question, following the release of the latest Labour Force Survey, covering the final quarter of 2018. Figures for employment, the labour force and the numbers unemployed are derived from that survey, based on a sample of households, and it is often the case that the published monthly unemployment estimates are then revised. That is again the case; the q4 average unemployment rate  is now put at 5.7% from the previous 5.4%, with the January figure  also revised up to 5.7%.

In fact  it now transpires  that the unemployment rate is unchanged at 5.7% for the past six months, with the actual numbers unemployed some 10,000 higher in January than previously thought. Indeed, seasonally adjusted unemployment, now at 137.000, has been ticking up for the past five months, so the prospect of a sub-5% unemployment rate  suddenly looks optimistic rather than realistic.

Why is the unemployment rate becalmed? A decline requires  employment growth to outpace that of the labour force which has been the case since early 2012. For example, the annual change in employment in q4 was 50,000 or 2.3%, against a 35,000 (1.5%) increase in the labour force, resulting in a fall in the unadjusted unemployment rate to 5.4% from 6.1% a year earlier.

The pace of employment growth slowed in the second half of last year, however;  the seasonally adjusted increase was only 8,300 in the final quarter, following a 9,500 increase in q3. Labour force growth over that period was 20,000 , so giving rise to the modest tick up in  the numbers unemployed and an unchanged unemployment rate.

Where to from here? A key driver of any change in the labour force is the participation rate ( the proportion of those  over-15 in the workforce).The Irish participation rate ticked up in response to brighter employment prospects but has been broadly unchanged now for some time, at around 62%. If that  continues the labour force will grow at the same pace as the over-15 population, currently at 1.5%, implying an annual rise of around 35,000. Unfortunately, employment growth, having slowed in the second half of 2018, is now  down to that 1.5% pace.

Brexit related uncertainty may be a factor on the employment side but it could well be that the  decline in Irish unemployment is  already at or near its cyclical low.

Ireland now a nation of savers, not borrowers

Much has changed in Ireland over the past decade and one of the most striking in economic terms is the  tranformation in Irish households from borrowers to savers although much of the coverage in the media  still concentrates on credit and the cost of new loans and so does not reflect this new reality. Ireland has morphed into Germany and we are now closer to Berlin than Boston.

Irish household borrowing peaked over ten years ago, in mid 2008, at €204bn, and most of this debt had been used to purchase residential property , which of course at the time had soared in value over a long period, leaving households with net worth of over €700bn. By 2012 the latter figure had collapsed to under €450bn, largely reflecting the 50% fall in house prices, but debt was also declining, given little or no new borrowing and the ongoing repayment of mortgages.

Indeed, household debt is still falling, at least on the figures to the third quarter of 2018 as published by the Central Bank, to €137bn , a reduction of €67bn from the peak.  Household income is growing strongly again and so the debt/ income ratio, a standard measure of the debt burden , is now down at 126% , a level last seen in 2003. Rising house prices and  the recovery in equity markets in recent years has boosted wealth, leaving net worth well above the previous peak, at €769bn.

Interest rates are historically low ( the average rate on new  mortgage loans is around 3%)  and wealth is at record levels so one might imagine that households would be reducing savings and increasing debt but that is not the case. New mortgage lending  has certainly picked up, reaching €8.7bn in 2018 as a whole, but that was largely offset by redemptions, leaving the net change in mortgage credit  on the balance sheet of Irish  banks at only €1.1bn. A rise nonetheless, but that is not inconsistent with the overall data on household debt, as that relates to the third quarter and includes money owed on mortgages no longer on the balance sheet of the original lender.

Central Bank controls now limit the degree of leverage allowed in the mortgage market and the relatively limited supply of new housing is also a contraint  so we are unlikely to see an explosion in household borrowing, even in an environment with less economic uncertainty. However, the savings side of the balance sheet is also witnessing a profound change, with a huge increase in the amount of wealth held in cash and deposits; the q3 figure was € 143bn , a €15bn increase in the past three years. So Irish households now hold more in cash and deposits than they owe in outstanding loans (€137bn), quite a change,  and this  has also had a major effect on Irish headquarterd banks, as they are now in effect Credit Unions, with loans amounting to only 93% of total deposits.

The returns on these deposits are also extraordinarily low of course, amounting to an average of 0.29% for outstanding deposits (the euro average is 0.3%) and a meagre 0.04% on new term deposits ( euro average 0.3%). Monetary policy is based on the notion that the economy responds to a change in interest rates, and that a substantial decline in rates will boost credit growth and encourage savers to spend and borrow. That certainly has not been the case in Ireland and so it is not clear what the impact of higher rates will be on what is now a net savings economy, if and when that day arrives. As it stands that  day seems far off, with the market not priced for an ECB rate rise till around June 2020, although that can and will change with the flow of economic events.

Marked slowdown in growth of average new mortgage in 2018.

New mortgage lending in 2018 emerged in line with our expectations,continuing to grow but at a slower pace than the previous year, reflecting the impact of tighter Central Bank controls and the absence of adequate housing supply. The fourth quarter figures also confirm that the average mortgage is still rising but at a much slower pace, consistent with an easing in house price inflation.

FTB lending in the first half of the year was  growing at a pace well ahead of the Central Bank’s limits , implying a need for mortgage providers to curb lending growth in order to end the year in compliance with the controls. There was certainly  a notable weakening in mortgage approvals over the summer months, with annual declines, before a modest pick up again in the final quarter. Actual drawdowns in q4. at 9,600, were  much stronger relative to approvals than earlier in the year, so by acting  on approvals banks had  now secured some headroom to meet the Central Banks annual lending limits.

The stronger final quarter brought total drawdowns for house purchase for the full year to 32,123, and 9.2% ahead of the 2017 figure. This represented a notable slowdown in lending growth as the latter had risen by over 18%. In value terms, new lending for house purchase rose to €7.3bn last year, a 13.5% increase  on 2017, but again this represents a pronounced deceleration in the pace of growth. from 29%. What is most striking in the data is the trend in the average new mortgage for house purchase, which averaged €226,000 for the year, a rise of just 4%, with the final quarter showing an annual increase of only 1%. This is consistent with slowing house price inflation and also indicates that affordability is becoming a bigger issue.

Another notable trend in the BPFI figures is the strength of re-mortgaging, which rose from €700m in 2017 to €1.2bn in 2018, with top -up mortgages at €221m. Indeed, lending for house purchase last year fell to 80% of total mortgage lending, from over 90% pre the Central Bank controls. Total mortgage lending in 2018 was therefore €8.7bn (i.e. house purchase plus re-mortgaging and top ups) as against €7.3bn in 2017 and a cycle low of under €2.5bn in 2011.

For 2019 , the outlook is likely to be strongly influenced by the shape of Brexit that emerges  as expectations play a strong role in both mortgage demand and housing supply,  so the market would be badly affected by an outcome which results in a UK recession, with significantly negative implications for Ireland. Absent that, transactions, which probably grew by less than 5% last year ( the CSO data is only available till November) will likely pick up, given stronger house completions, so boosting the volume of new loans, but against that weaker house price inflation will dampen the size of the average  new mortgage and hence the growth in the value of lending.We will produce a more detailed forecast in the next few weeks.

ECB rates lower for longer , Redux

Last June the ECB had grown more confident that the ongoing economic upturn would eventually result in inflation rising to nearer their target and at that month’s press conference announced that net asset purchases would ease and eventually cease at the end of the year. The Governing Council also made a significant change to its forward guidance on interest rates, which were now expected to remain at existing levels until ‘through the summer of 2019’, so replacing the previous ‘extended period’ with a more specific date for the first upward move.

At the time headline inflation had risen to 1.9%, with the ex-food and energy measure at 1.3%. Euro area growth was  expected to moderate only marginally, to 1.9% in 2019,  so the idea that the monetary policy stance was likely to change seemed plausible, and the markets duly priced in a 10bp increase in the deposit rate  for around September 2019.

Events did not materialise as the ECB expected, however. Growth in the EA slowed to 0.2% in the third quarter, with Germany and Italy both experiencing contractions, and the high frequency data implies that the fourth quarter figure could be weaker still. Consequently, the annual growth rate in q4 may well slow to 1.1% and initial indications from the January PMIs imply an annual figure of well below 1% in the first quarter, which makes the Bank’s 1.7% average growth forecast for 2019 look very optimistic. Inflation, too, has disappointed the ECB, with the ex food and energy rate seemingly anchored at 1.1%, with a core figure of 1%.

Some observers, including many on the Governing Council, had expected the slowdown that emerged in the second half of 2018 to be short-lived, particularly as the US economy is still growing strongly, albeit at a less dynamic pace than earlier in the past year. It now appears that others on the Council have become more concerned that the slowdown could be more protracted, and at the latest  ECB press conference the risks to the outlook were now deemed to be on the downside. Indeed, Draghi actually used the term ‘recession’, albeit giving it a low probability.

The ECB prefers to announce policy changes against the backdrop of a fresh set of forecasts, and so it chose to leave its current forward guidance on rates unchanged. That ‘summer of 2019’ guide now looks redundant, however, at least as far as the market is concerned, with the first rate rise now pushed out to around June 2020.  Longer term rates have also fallen, with 10-year Bund yields back below 0.2%, while  the cost to a commercial bank with a good  credit rating of borrowing three year money is -7 basis points. The euro has also faltered , and is trading back below 87 pence sterling. In fact Draghi acknowedged the divergence and implied that the Bank might well have to change its guidance at the March meeting, when of course it will have an updated set of staff forecasts.

There is still an enormous amount of excess liquidity in the euro system (around €1,800bn) but there is also some speculation that the ECB may announce a further TLTRO, which  was introduced in 2016 and is currently providing over €700bn in long term funding to euro banks at negative or zero rates, with a high uptake from  Italian and Spanish banks. For a number of reasons a substantial repayment may take place in June, prompting talk of an additional tranche to maintain high liquidity levels.

The economic outlook can change, of course, and a combination of a managed Brexit alongside an easing of trade tensions could spark an upturn in activity, hence prompting a change in rate expectations. The ECB also seem more concerned than in the past about the impact of negative rates on bank margins, another argument for moving rates up. Against that, the data flow remains relentlessly negative and there must be a risk that the ECB may have to change stance again, and adopt  additional measures to support activity. A generalised slowdown or recession would also probably prompt a big EU rethink on the fiscal side as monetary policy has taken most if not all of the strain in recent years.