Irish Consumer spending accelerating despite deleveraging

Following the  recent revisions to the Irish National Accounts it appears that  the recovery has been stronger and less volatile than previously reported, leaving real GDP in the first quarter of 2015 3.9% above the pre-crash high. Forecasts for economic growth this year are also moving up, including  revisions to estimates for consumer spending, but the latter may still be too low in our view as we expect real personal consumption to rise by 4.2%. This compares with the Department of Finance’s 2.4%, the Central Bank’s 2.3% and 2.0% from the ESRI, although all  these were made before the release of the  official Q1 data.

Forecasters have generally become cautious about consumer spending in the wake of previous projections which had proved optimistic, in part because of the uncertainty about the pace of debt repayment by Irish households.  Debt peaked in late 2008 and has fallen  by almost €50bn  to stand at €154.6bn in the first quarter of 2015. This is still high by international standards , at an estimated 166% of disposable income, but is a far cry from 211%, the debt burden at the peak of the cycle.

So debt reduction rather than debt accumulation has been a key feature of Irish household behaviour over the past seven years, which has acted to dampen consumer spending. A corollary is that the gross savings ratio has risen sharply. from 7%  of disposable income in 2007 to a peak of 16.7% in 2009  and  a 12%-13.5% range  in recent years.

The published data on consumer spending has also appeared at variance with that on retail sales, with the latter implying stronger spending than actually recorded in the national accounts. One factor here is the impact of tourism, which affects retail sales but is excluded from Irish consumption. Another issue is the price deflator used to adjust nominal spending to derive real personal consumption. That deflator has been much higher than either the deflator for retail sales or from the CPI, and probably reflects the inclusion of imputed rent in the personal consumption measure, as private sector rents have been rising at an annual 8%-10% for the past few years.

Yet recent developments still point to a strong pick up in consumer outlays. First, spending over the past few years has been revised up, and has risen consistently  for the past eight quarters, with an acceleration evident in the second half of last year. Second, spending grew by 1.2% in the first quarter of 2015 and at a 3.8% annual rate. Third, retail sales have been much stronger this year, boosted by a surge in car sales ( up some 31% in the first half of 2015) . Fourth, sales excluding cars, a better proxy for overall consumption, have also grown at a robust pace, with the annual increase accelerating to 6.6% in the second quarter from 5% in q1. This implies a stronger annual increase for personal consumption in q2, even allowing for the rental price effect.

A number of other factors also support the case for stronger consumption. Household income is now growing, expanding by 3.2% in 2014 following a 1.1% advance the previous year, and is likely to continue to grow at a faster pace this year , given the ongoing rise in employment and signs that wages are starting to pick up. Consumer prices are still falling, which also will help and household wealth is recovering, having risen by €154bn or 35% over the past two years. It is impossible to gauge when household deleveraging will end, but on the recent evidence the impact of debt reduction on personal consumption is being more than offset by a number of other developments, all  supporting stronger personal consumption .

Irish Economy soaring, now well above pre-crash peak

The CSO has just published the Irish National Accounts for the first quarter, incorporating data revisions and an adjustment for aircraft leasing, with gross aircraft flows now  included as against a net figure. In the event the  combined impact was substantial, with upward revisions to all GDP components, leaving nominal GDP in 2014 at €189bn compared with the previous estimate of €185bn. In real terms the recession in 2008-09 is now seen to have been milder, albeit a still bleak 9.8% fall in GDP over 8 consecutive quarters, with the recovery stronger; the  new data  shows the  economy to have grown in every one of the past five years, with the 2014 initial estimate of 4.8% now put at 5.2%. As a result  it now appears that all the output lost in the crash was recovered by the third quarter of 2014  and real GDP is  currently 3.8% above the previous peak recorded in the final quarter of 2007.

The pattern of the recovery as previously understood remains broadly intact, with a positive impact from external trade offsetting falling domestic demand, although the latter is now seen to have grown in 2012 , driven by investment spending, before declining again in the following year. Consumer spending  of late is now  stronger than previously recorded , which is more consistent with retail sales , while GDP as a whole is now better aligned  with the recovery in employment, which started in early 2013.

The recovery picked up strong momentum in 2014, with  all the 5.2% expansion in real GDP driven by domestic demand, led by double digit growth in business spending on machinery and equipment alongside a 10% rise in construction. Consumer spending also grew , by 2%, although the reported 4.6% rise in Government spending is more difficult to fathom, and appears to be related to  the productivity gains assumed to flow from the Haddington Road agreement with public sector unions

The previously published data had shown a marked slowdown in the second half of last year but that has now been revised away, with the result that the economy entered 2015 in a stronger position than initially thought. Moreover, growth in Q1 was also robust, at 1.4%, leaving the annual change in real GDP at 6.5%. Consumer spending is now rising strongly in volume terms, by an annual 3.8% , although the annual growth in investment spending slowed to 4%, albeit dampened by the volatile aircraft sector.

Net exports also made a strong contribution to the annual growth figure in q1, adding 2.1 percentage points, with the  figures now reflecting aircraft leasing as well as last year’s methodological changes. Exports grew by an annual 21% in value terms ,and by 14.3% in volume terms, with the latter marginally lagging import growth of 14.7%, although such is the scale of exports that a similar growth figure in imports still generates a strong net contribution from the external sector.

The external data has also confounded the many looking for much smaller  gains in 2015, and that, alongside the GDP figure itself,  will likely prompt upward revisions to growth  forecasts for 2015 as a whole. The nominal rise in GDP in q1 was also surprising (an annual 12%, largely reflecting a big increase in export prices)  and estimates for nominal GDP  growth  this year may well be raised to at least 10%. The latter would mean a 2015 figure of €208bn, implying a debt ratio around 102% and a fiscal deficit under 2% of GDP. Good news then, but one  final implication: the Central Bank, IFAC and the ESRI have already urged the government to reduce the size of the proposed fiscal stimulus  in the 2016 Budget and the figures published today strengthen their case, it would seem, although one doubts if that  will cut much ice with the governnment ahead of the election.

 

Irish wages reflect market economy at work

There are two official sources of information on Irish wages and salaries, both published by the CSO.  One is an aggregate figure for the total paid out to employees and is published annually as part of the National Accounts . That series shows a modest increase in average pay over the past few years ( dividing total pay by annual employment ) which is at variance with the other data source,  a quarterly survey of employers across 13 industry sectors, which is also used to calculate total labour costs i.e. adding items such as employers’ PRSI.  The quarterly figures are also used to compile an annual data set and the CSO recently released the 2014 results.

Average  earnings came in at €35,768 per annum , marginally (0.2%) down on the previous year which in turn had seen another modest fall of 0.7%.  Pay peaked in 2009 at over €36,800 so the past five years has seen a fall in excess of €1,000  or 3%. Remember this is gross pay and takes no account of changes in tax and PRSI, and the average tax rate has risen over that period. Consumer prices are also higher, by 4%, so real gross pay has  fallen by almost 7% with a larger fall evident in real take-home pay.

The average  earnings figure for the whole economy masks  divergence across sectors, as one might imagine in a market economy with no central bargaining mechanism. Earnings in industry, for example, rose by 3.6% last year and continued to rise through the recession, with the result  that pay in that sector is now 5.7% above the 2009 figure. Pay in Information and Communication has risen  at an even faster pace over the past five years, by 10.7%, with the financial sector also seeing a strong increase of 8.3%, although that was strongly influenced by a 4% rise in 2014. Employees in the retail sector have also experienced a rise in gross earnings since 2009, of 4.8%.  Pay is down across all other areas  of the private sector, however,  and the public sector has seen notable  falls, including 11.5% in Health, 10.6% in Education and 7.3% in Public Administration.

The 2016 Budget may deliver an increase in public sector pay but the general pick up in domestic economic  activity since 2013  is  already having a discernible impact on private sector earnings. Construction output has rebounded  and 2014 saw a 4.6% increase in average pay in the sector, following a  2.1% rise in 2013. Similarly, the upturn in tourism is beginning to benefit employees in the Food and Accommodation sector, with pay there rising by 3.4% last year. Indeed, total pay in the private sector as a whole rose by 0.6% in the year to the first quarter of 2015 (   one should note that the quarterly data is prone to substantial revisions) and the consensus view is that the next few years is likely to see average earnings on a rising trend given the pattern of employment growth and the steady decline in the unemployment rate, which is now under 10% from a high of over 15%. Some sectors are likely to do better than others, as is inevitable in  a market economy with a  flexible labour market, although  the  recent experience of the US and the UK  suggests that  the pace of growth in average pay is  likely to be  subdued by historical standards.

Mortgage arrears model points to further decline this year

Residential mortgage arrears in Ireland are extremely  high, both in absolute terms and relative to comparable housing markets.  At the peak of the cycle , 130k  mortgages were over 90 days in arrears , equivalent to  1 in 7 of outstanding mortgages owed to domestic lenders.  In the UK the figure peaked at a little over 1 in 100 and  in the first quarter of  2015 the total amounted to just 114k, in a market with 11.1 million mortgages. The good news is that the  Irish figure is now falling steadily, and our arrears model points to a further decline this year, in the absence of a significant shock to the economy.

Residential mortgages have been treated differently to other assets by the Irish  banks.  Real estate and commercial property loans were sold to Nama in 2010 for 43 cents in the euro, so crystallising a €42bn loss for the banks and opening up a capital hole subsequently largely filled by the Irish taxpayer.  Residential mortgages were not marked to market, in contrast, and arrears built up rapidly, reflecting , inter alia, societal pressure against large scale repossessions, the absence of foreclosure on any scale in modern Ireland,  some legal issues, political unease and a reluctance by the banks themselves in an environment of falling property prices and capital constraints.

Arrears on Private Dwelling Homes (PDH) are largely driven by three factors. The most important is unemployment, as the loss of a job and subsequent hit to income is one of the main reasons why mortgage payments cannot be met. The numbers unemployed in Ireland soared during the recession, from under 100k to a peak of 325k in late 2012, with the result that arrears  climbed rapidly. Interest rates matter too, although the impact is not as significant, and the decline in  mortgage rates since 2008 has had some offsetting impact on arrears. A third factor is house prices, perhaps surprisingly, but the relationship is clear in the data; the fall in residential values from 2007 to 2013 was a factor in pushing up arrears , with the scale of negative equity appearing to influence the decision on whether to continue to meet the monthly mortgage payment.

All three factors , with varying lags, help determine the level of PDH arrears in our model, which has performed reasonably well in tracking the 2013 peak and subsequent decline; PDH arrears in the first quarter of  2015 had fallen to 74k (9.7% of  the outstanding stock ) from a high of 99k (12.9%). House prices are now rising, so putting downward pressure on arrears , but the main driver of the fall is the improvement in the labour market and accompanying decline in the numbers out of work. As noted, these explanatory variables enter the equation with a lag so we can forecast arrears forward, given the current level of interest rates, unemployment and house prices, and that points to a figure around 50k by year-end, or well under 7% of the PDH mortgage stock. All econometric equations have a margin of error, of course, and debtor behaviour can change, particularly in response to  an economic shock or a perceived change in the attitude of lenders. The last few months has also seen a marked slowdown in the pace at which unemployment is falling, which if sustained will impact arrears into 2016.

There is less data  available on Buy to Let  (BTL) arrears and there seems to be other factors at work, making it difficult to derive a parsimonious model. Arrears in this market are proportionately much higher than private homes, although they  also appear to have peaked,  albeit a year after PDH, and are also now declining ; the q1  figure was  27k ( 19.7% of the total stock) from a  high of 32k (22.1%). The different drivers in BTL are also evident from the decision by lenders to send in rent receivers in order to recover mortgage payments, with the total rising to 6k in the first quarter.

The improvement in the economy and the recovery in the housing market have therefore resulted in a brighter picture on arrears, although these  factors have also prompted a change of tack on repossessions ( the sale of loan books, a return to bank  profitability and  a new  financial regulator in Frankfurt  have no doubt also played a part). The flow  of properties into repossession has certainly increased, rising to 557 in q1 from 354 a year earlier ( half the total is voluntary ) and that figure looks likely to rise, given the reported numbers before the courts.

Irish House Building picking up, but still well short of demand

Contrary to perception, the evidence over the past 20 years is that the supply of Irish housing is responsive to demand. The geographical distribution of that supply  may be far from optimal at times but the national figures suggest that house building does indeed respond to price signals; completions amounted to 30k in 1995 and by 2005 had risen to 86k before falling away precipitously as prices tumbled, declining to a cycle low of 8.3k in 2013. The latter added 0.4% to the housing stock which is well below  the depreciation rate , a far cry from the peak of the cycle when the housing stock was growing by over 5% per annum.

National residential prices  have risen by 26% over the past  two years, and one might expect  this should prompt a significant supply response. That is certainly the case in percentage terms, although the absolute numbers are still very low by historical standards; completions rose by 33% in 2014 but still amounted to  just over 11k,  again well below the depreciation rate, which is probably around 0.7% or 14k given the current stock of housing.

A number of recent studies put the annual increase in demand for housing in Ireland at some 25k, although this is sensitive to assumptions about migration flows. The figure for Dublin (city and county) is around one-third of that total and supply is  clearly well below that, both nationally and in the capital. The Department of the Environment (DoE)  has just published completions for the first quarter of 2015, with a national figure of  2.6k. Again this represents a substantial percentage gain on the same period a year earlier (26%) but if replicated over the rest of the year would still leave annual completions in 2015 at under 14k.

The pace of completions may change, of course, but the traditional lead indicators have proven a less reliable guide in recent years. New home registrations have picked up but amounted to only 2.5k in 2014, with the discrepancy between that total and the completions figure partly reflecting the decline in the share of building accounted for by multiple developments (well below 50% in recent years) and the fact that the DoE data defines completions as housing connected to the electricity grid. The latter point may also be a significant factor in the dichotomy between commencement notices  and completions (7.7k of the former in 2014 versus over 11k of the latter). The relationship between completions and planning permissions is also not close, at least in the short term, and although permissions have picked up they are also running at very low levels ;  7.4k last year, up from 7.2k in 2013.

The latest  house building data also provides little comfort for those looking for a substantial rise in supply in the capital. Total completions in  Dublin city and county amounted to just 652 in Q1,  204 apartments and the rest houses. This is less than 25% of the national total, suggesting that supply in the capital is not only lagging demand but also not keeping pace with the increase in supply nationally.

The conclusion has to be that supply is indeed responding to the recent price appreciation but that the absolute numbers  completed are still very low and certainly still well short of what is generally felt to be the annual demand. Absent a demand shock, the housing market is likely to remain unbalanced for some time, particularly in Dublin.

Euro Fiscal Rules to the fore in Irish Medium Term Outlook

The Irish Government has just published the annual Stability Programme Update, incorporating macro-economic projections out to 2020 and  a forecast of the fiscal position over that period. The figures indicate that this  Administration has the scope to deliver some further modest tax reductions in the 2016 Budget, and no doubt that will  garner the most column inches, but a key feature of the text is the degree to which EU fiscal rules will remain a constraint for Irish Budgetary policy.

The near term economic and fiscal outlook certainly looks brighter than it appeared in last year’s Update, or indeed at the presentation of the 2015 Budget (in October last year). Tax receipts are running well ahead of target and the Department of Finance now expects a €1bn overshoot, which appears conservative. Non-tax receipts have also surprised to the upside , thanks to a higher Central Bank surplus, and debt interest is now expected to be substantially lower than initially forecast. Capital receipts are also likely to be well ahead of the Budget projection, with the result that the Exchequer deficit ( the cash sum that  it needs to  borrow ) is now forecast at  €3.5bn instead of the initial €6.5bn. The impact on  the  General Government deficit is not as large ( some of the unplanned capital receipts are excluded ) and that is now expected to come in at €4.6bn, or  some 2.3% of GDP , against a Budget target of 2.7%.

Surprisingly, perhaps, the Department has resisted the temptation to  materially revise its previous growth forecasts; real GDP in 2015 is now projected to increase by 4% instead of 3.9%, with 2016 now 0.4 percentage points higher, at 3.6%, but growth in each of the next two years is now expected to be 0.2 percentage points lower. Nominal GDP is forecast to rise strongly this year, up 6.9%, but by 2018 is only 1% higher than previously envisaged.

In the past greater tax buoyancy often resulted in higher exchequer spending and/or tax reductions ( ‘if I have it I’ll spend it’, to quote Charlie McCreevy) but Ireland’s membership of the euro imposes fiscal constraints. One, under the corrective arm of the Stability and Growth Pact,  was the requirement to reduce the  fiscal deficit to under 3% of GDP. That achieved, Ireland has now to adhere to the Preventive arm, and this imposes two constraints over the next few years.

The first is that Ireland has to move to a structural budget balance ( the actual balance adjusted for the economic cycle). According to the EU Ireland is now operating around full capacity ( a strange assumption, in truth ) so none of the actual  deficit forecast for 2015 is deemed cyclical. Hence the structural deficit is projected at 2.6% and under the rules Ireland has to reduce that by at least 0.5% of GDP each year.

A second rule, designed to complement the first, limits the  amount the government can spend. Certain items are excluded from the requirement, such as debt interest, capital spending and some unemployment benefits , which in Ireland’s case means  that €66bn falls under the with the limit, from a grand total of €73bn. The former can only grow in line with the potential growth rate of the economy or in Ireland’s case at a lower rate in order to ensure that the structural deficit declines. That potential growth rate is in turn calculated periodically by the EU, and it appeared that the existing  formula would leave the Government with little room to manoeuvre  in the 2016 Budget ( with little ‘fiscal space’ in economic jargon) . However, the EU has now been persuaded to update potential growth estimates on an annual basis and although spending is still constrained the permitted rate of  spending growth in Ireland has increased, to 1.6%, and it  now appears that the Government has around €1.3bn in terms of ‘fiscal space’, or around €1bn more than envisaged a few months ago, Those additional resources , according to the Minister for Finance, will be used to increase spending by around €0.6bn in 2016 while also reducing taxation by a similar amount.

One issue is that the structural deficit is only projected to decline by 0.4 percentage points in 2016 ,to 2.2%, which may cause problems for the EU. Further out, the Update projects that tax receipts will rise slightly faster than GDP and that the structural deficit  will decline by 1% per annum in both 2017 and 2018 , before moving to surplus in the following year. Yet  that outcome is achieved by assuming  unchanged  current spending in nominal terms, which is clearly incompatible with any real increase  if inflation is anything above zero.  The implication is that any Irish government, of whatever political hue, will continue to face significant fiscal constraints over the medium term, and the limited resources available will intensify the debate about  the efficacy of tax cuts as against  spending increases.

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.

Employment in Ireland regains momentum in second half of 2014

On the basis of Ireland’s quarterly GDP data the economy hit bottom as far back as the final few months of 2009, although no one felt that the following few years could be described as a recovery. This was partly due to the limp and volatile quarterly pattern of the GDP data and, perhaps more importantly, the continued fall in the numbers at work. Employment didn’t hit bottom until the third quarter of 2012, but the past two years has seen a clear and marked improvement in the labour market, which is probably  a better barometer of the health of the economy than the headline GDP data .

Indeed, as an earlier Blog pointed out , the relationship between job growth and GDP of late has been odd. Employment ( when adjusted for seasonal affects) rose by some 58k through 2013, although GDP was broadly unchanged (growth is currently put at 0.2%).  Yet we know that GDP grew strongly in 2014 ( the final figure, due in March, may show growth in excess of 5%) but employment growth was actually weaker, with a total rise of 27k over the four quarters.

That weakness was most pronounced in the first half of the year, with employment rising by over 6k, but the pace quickened in the second half of 2014 as confirmed by the q4 Quarterly National Household Survey; employment rose by around 20k in the final two quarters , bringing the total number of jobs created in the year to 27k and the overall figure during the recovery to 95k.

The sectoral pattern of job gains as revealed in the CSO data is unusual, however.The rise in employment was initially driven by  agriculture  ( accounting for over 40% of the rise in 2013!) and the hotel sector, but in 2014  employment fell  sharply in agriculture  and although virtually all other sectors saw some job gains (there were marginal falls in Public Administration and Health) some 45% of the rise in employment was again attributed to just one sector, this time Construction. Perhaps the original rise in agriculture reflected rural construction workers  returning to farming and this has now partly reversed, given the upturn in house building and other construction.

The labour force also declined sharply during the recession ( a peak to through fall of 128K) before recovering by some 20k  in 2013 ( a better chance of  employment can encourage people back into the work force). The labour force started falling again in the first two quarters of 2014, however, and although the second half saw a modest rise it was not sufficient to prevent a 10k fall in 2014 overall. That leaves the total off the lows but it is far from clear how the labour force performs from here- will the recent fall in net emigration continue and hence  help to boost the numbers seeking work in Ireland or will the fall in the participation rate continue, so keeping downward pressure on the labour force?

That uncertainty about the supply of labour will affect the unemployment total and the unemployment rate but for the moment at least the scale of employment growth is driving a sharp fall in the latter, which declined to 10.4% in the final quarter of 2014, the lowest since early 2009 and a long way below the peak of 15.1% recorded three years ago. Indeed, the q4 figure was also below the initial 10.7% ( based on monthly estimates). That means that the January estimate has been revised to 10.3%, implying that on the basis of the current trend the unemployment rate will fall below 10%  in May or June.

Falling Prices versus Deflation

Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2%  Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the  euro  inflation rate  towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?

Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity  prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts  envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.

If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case  against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than  half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in  the CPI would probably in turn require a prolonged and heavy  fall in wages. Ireland has seen a  modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts)  while wage growth is positive on average across the euro area.

The performance of  euro equity markets would also suggest that deflation is not a base case,  and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices  next year. Deflation will also  affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.

The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond  yields)  popular as they can be monitored in real time. On that basis the US market is expecting inflation  to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.

Evidence, then, that inflation is expected to be low and certainly below  the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.

 

Irish petrol prices under downward pressure

Spending on energy accounts for over 10% of the average Irish household budget and the volatility of energy costs is often a significant factor in the swings evident in the  overall inflation rate. The past year has seen a much more stable picture,  however, and in September energy prices were 1.7% below the same month in 2013.  Spending on petrol  and diesel accounts for over half the total energy spend and prices there have also fallen , by some 4% over the past year. The price of petrol at the pump has also eased over the past few months and currently averages around €1.50 a litre, from  €1.57 in July. Further falls are likely in the near term  in the absence of a significant fall in the euro, to perhaps  around €1.47,  given the events unfolding in the oil and gasoline markets.

Tax accounts for around 55% of Irish petrol prices but the recent Budget left fuel alone, following a series of tax increases since 2009, amounting to over 20 cent per litre. Apart from the Exchequer, the price of petrol is largely determined by three factors; the price of crude oil, the value of the euro against the dollar and refinery margins. The global demand for crude is rising but at a slower pace than most expected  -the International Energy Agency has just revised down its forecast for this year and next-reflecting sluggish world growth and a steady decline in the amount of oil required to produce a given unit of output;oil provided 46% of world energy needs in 1973 but only 31% today..The biggest recent  change in the global oil market has come from the supply side, however, with a large increase in non-OPEC production; in the past year non-OPEC supply has increased by over 2 million barrels per day  and in the near term increased production from that source is expected to more than offset any likely increase in overall  global demand. A big factor in that change is the increase in output from the US (in part reflecting the impact of oil from Shale sands) with production there currently challenging Saudi Arabia for the title of largest world producer.

The price of Brent Blend, the European crude benchmark, has fallen by 22% over the past three months, to around $85 a barrel in the face of these demand and supply changes. The euro has also fallen against the dollar over the same period but the decline there has been much  less pronounced, at around 7%, so in euro terms crude oil is now some 15% cheaper than it was in mid-July. In the medium term the price of crude will determine the price of refined products, including petrol, but in the shorter term the margin that a refinery can make  by ‘Cracking’ the barrel of crude (the ‘Crack spread’) can vary, depending on local demand conditions and the degree of excess capacity in the industry. Crack spreads in Europe have been higher in recent months than they were a year ago  but the wholesale price of gasoline has fallen sharply of late and now broadly reflects that of the fall in crude.

A 15% fall in the wholesale price of petrol  over recent months would therefore imply a 7% fall in prices at the pump from the mid July level  (given  over half the price is tax) which would leave average prices around €1.47 a litre. Price will vary around this, of, course, given local supply and demand conditions but most areas should see some price declines, although the demand for petrol is now rising again nationally, which may also influence retail margins. The main risk to that outcome relates to the euro, which has regained some ground of late but still looks vulnerable given the economic backdrop .

 

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