Powell Rules

There’s a new kid in town. Jay Powell’s first major speech as Chair of the Federal Reserve, the Monetary Policy Report to Congress, had an immediate impact on markets, interpretated as indicating a more hawkish stance than his predecessor. Time will tell but one interesting feature of his speech was his emphasis on monetary rules in setting policy, which  he finds ‘helpful’, with an analysis of five such rules detailed in the Report.

It seems clear that the Fed do not slavishly follow any rigid precription in setting interest rates, although the rate paths implied by the various rules  are apparently set out ahead of FOMC meetings in order to act as a guide, and Powell’s speech is likely to stimulate further market interest in this area.

The best known rule is named after John Taylor , and posits that the Fed funds rate should move by precribed amounts from its long run equilibrium level  ( which on current FOMC forecasts is 2.75%) if inflation differs from the 2% target or if the real  economy  has moved away from its full employment level, which the Fed currently believes is consistent with an unemployment rate of 4.6%.

What does the Taylor rule imply now? The Fed expect inflation in 2018 to pick up to 1.9% but that the unemployment rate by the final quarter of the year will have fallen to 3.9% and so below the long-run equilbrium level , indicating that tighter policy is required, with an implied  Fed funds rate of 3.3%, which is around 1% higher than the median FOMC expectation as set out in the ‘Dot Plot’.  In other words rates would rise more rapidly than curently envisaged by the market , although over the following few years the ‘Dot Plot’ converges to the Taylor rule, albeit with the latter implying a modest easing of policy while the former points to a steady tightening. The Taylor rule also implied the need for negative rates following the financial crash and an “Adjusted Taylor rule’ take account of this insufficient monetary accommodation in the past by advocating a gradual return to the rate implied by an unadjusted Taylor rule, although the former has now largely converged to the latter.

What of the other rules discussed? A ‘balanced Approach’ rule gives a greater weight to deviations from full employment and that also indicates that policy is too accommodative, and indeed should be much tighter by end-year, with a Fed funds rate of 4%, before falling back to 2.75% in the long run.  Not all rules imply the Fed is behind the curve, however, with the other two rules discussed arguing against aggressive tightening. One, the ‘First Difference rule’ takes account of the current level of the Fed funds rate and the pace at which unemployment is changing, and implies a policy rate of 1.75% by end-year, which is below the ‘Dot Plot’ figure . Similarly, another variant, ‘the ‘Price Level rule’, implies that policy is also too tight now and as projected because the rule adjusts for the fact that inflation has been below the 2% target for some time, so the price level is therefore lower than would be the case had inflation been at 2% every year.

All such rules are based on simplified models of complex  and changing dynamics in the US economy, but ,as Powell noted, can be useful for policy makers . Three of the five imply that rates are too low given the Fed’s expectations for inflation and unemployment which may prove more significant with Powell at the helm.


Modest rise in Irish pay in 2017, led by public sector

Pay growth has been modest by historical standards across many developed economies in recent years, despite tightening labour markets, and Ireland is no exception- average weekly earnings  only started to rise again in 2014, and average  annual increases of around 1% have been the norm. Unemployment peaked in early 2012  at 16%, and has been falling steadily since, declining to 6.2% at the end of 2017, so one might expect that firms would have to increase pay to attract and retain labour.

Average weekly earnings did pick up through 2017, according to the latest CSO data, rising by by annual 2.5% in the final quarter of the year, which brought the annual average increase to 2%. The growth in private sector earnings last year was lower, at 1.8%, and was outpaced by the 2.6% average rise in the public sector. Pay in the latter is on average 41% higher than in the private sector, but has generally lagged since 2008, when the differential was 46%.

Average pay masks large differentials across the various sectors in the economy and the the recovery has been kinder to some workers than to others; the earnings of workers in Information and Communication, Scientific and Professional services and Adminstration and Support have all  significantly outstripped the average growth in pay, while the Financial sector has recently recorded strong pay growth after steep falls during the recession. Surprisingly, perhaps, pay in construction is not as buoyant as one might imagine, with average earnings barely increasing in 2017 and still below the 2008 level.

Consumer prices rose by only 0.4% last year so a 2% pay rise translated into a 1.6% increase in real earnings. Nominal pay growth is generally expected to accelerate in 2018, given the further erosion of slack in the labour market, although, as seen elsewhere, the traditional relationship between unemployment and pay growth, the Phillips Curve, has become much flatter,


Irish new mortgage lending rises by 29% in 2017 but affordability is deteriorating

Irish mortgage providers lent €6.4bn for house purchase in 2017, the strongest figure since 2008, with top-ups and re-mortgaging bringing the total to €7.3bn, a 29% increase on the previous year The final quarter was particularly strong, when adjusted for the usual seasonal effects , and we expect further growth in 2018, although affordability is deteriorating and the Central Bank’s modifications to its mortgage controls will no doubt have some impact on First Time Buyers , as Loan to Income is the main constraint for that segment of the market. Indeed, there was a notable slowdown in approvals in the last few months of the year, perhaps indicating that lenders are already adjusting to the rule changes.

Drawdowns were very strong in the final quarter, nonetheless, with over 8,700 mortgages for house purchase including over 5,000 to FTB’s, some 60% of the total. For 2017 as a whole 29,400 mortgages for house purchase were drawn down, still a far cry from the boom figures in excess of 100,000 but significanttly above the low recorded in 2011 (11,000) and 18% above the total in 2016. The value of lending for house purchase implies an average mortgage of over €217,000, against €200,000 in 2016, and a cycle low of €174,000 five years ago.

Interest rates on new loan have not materially changed over that period and household incomes have risen but the increase in mortgage size is such that affordability, the ability to service a mortgage, has deteriorated. Our own model compares  the annual cost of a new , 25-year repayment mortgage to our estimate of gross  borrower income, and shows that the ratio rose to 30% in 2017, the highest since 2009 and above the long run average (back to 1975)  of  29.5. The ratio is still well below the heights recorded at the peak of the boom ( over 40%) but our forecast is for a further deterioration in 2018, to 31.2 , and this assumes no change in interst rates, so any rise in the latter  would indicate a greater deterioration.

At the moment a rate rise looks unlikely until 2019, at least, and the affordability change expected does not look material enough to have a significant impact on lending, given the prospect of further gains in employment, an acceleration in wage inflation and stronger house completions. Against that, the Central Bank’s changes to mortgage controls are undoubtedly a policy tightening, in our view, although not  sufficient to prevent further growth in new lending, and we anticipate a figure around €9bn in 2018. Net lending has also started to grow in recent months, so the coming year will probably see the first rise in Irish mortgage debt in a decade.



State’s strange move into higher risk, high leverage mortgage lending

First Time buyers accounted for 11,896 transactions in the Irish housing market in the first eleven months of 2017, which is 1700 up on the same period in 2016 but still only around 20% of total turnover. The Government has sought to support that segment of demand via a tax rebate to help those seeking to buy or build a new home (the Help to Buy scheme) and has just announced a fresh initiative, this time in the form of State mortgage lending ( Rebuilding Ireland Home Loan) , although the scheme has a number of odd features and appears a strange step to take.

To qualify, would-be borrowers have to have been rejected by at least two lenders, which immediately implies that the State would be taking on if not sub-prime then certainly higher risk loans. The lending decision will be taken by local authorities, so someone in those authorities will be making credit risk decisions, raising the issue of the criteria that will be used to decide which applicant is successful.

Third, the State is driving a coach and horses through the Central Bank’s mortgage controls and one wonders what the Bank makes of it and whether it was consulted. Lending institutions are required to limit mortgage loans to  a maximum of 3.5 times  the borrowers income , with 20% of lending to FTB’s  per annum allowed above that. The  specific limit  for FTB’s has just been introduced and represents a de facto tightening of standards, as 24% of lending to that segment exceeded the limit in the first half of 2017. Yet the State scheme allows a LTI range from 3.8 to 5.0, which is much higher leverage than deemed acceptable  to private lenders, and therefore higher risk.

The scheme does have a loan to value limit ( 90%) and a maximum property price, so putting a cap  on a given loan, although it does differentiate by location; properties in the major cities and in the counties surrounding Dublin carry a  maximum loan of €288,000 as against €225,000 elsewhere. Over 60% of transactions are in the former areas so the €200m allocated implies that less than 800 loans could be granted in 2018. Total mortgage lending for house purchase this year is likely to be around €8.5bn so the scheme is not material in terms of the overall market.

Finally, we have the issue of funding costs. Successful borrowers will have three options, two fixed rates and one floating, all well below current market rates. For example, a 25-year mortgage would cost 2% fixed, and a fixed rate for that term is not available from Irish banks- in general, banks can’t borrow at that maturity, so 3-5 year fixed  is the most common (although some 10-year is now available). The State can and has borrowed for 25 years and longer, with a bond maturing in 2045 trading at around 1.8%, implying a very small margin if that was tapped to fund this initiative.

Successful borrowers will be getting a cheap loan with the State taking on a level of risk that the private sector is unwilling to bear, at least at that cost, and indeed  what the Central Bank is also unwilling for borrowers or lenders to countenance.

The exchange rate and oil price, not growth, key for ECB QE exit

The consensus was badly wrong on the euro zone last year, significantly underestimating the pace of economic growth and the single currency’s appreciation against the US dollar. This year, growth is expected to remain strong and the euro is generally forecast to appreciate modestly, while many believe the ECB will cease its net asset purchase programme by year-end, with a strong majority of analysts also expecting that to be followed by a rate rise in 2019.

The ECB staff forecast also projects above-trend growth for the next three years, resulting in a steadty decline in the unemployment rate to an average of 7.3% in 2020, from over 9% last year. Yet inflation is still forecast to be below target in 2020, at 1.7%, despite years of QE and negative interest rates. Indeed, the December forecast actually revised down the Bank’s projections for core inflation ( the headline rate excluding food and energy)  by 0.2 percentage points over the next two years.

In fact the ECB has significantly changed its forecast relationship between growth and inflation, as indeed have many Central banks. In their macro models, stronger GDP growth leads to lower unemployment  which in turn boosts wage inflation and ultimately price inflation via higher costs for firms, which are passed on to consumers. But, as is now well recognised,the relationship between unemployment and wage inflation has changed and the ECB is now adjusting its forecasts to reflect that fact. Two years ago, for example, an unemployment rate of 10% was expected to generate a 2.1% rise in wages but in the latest forecast wage inflation in 2019 is projected to be below 2% despite an unemployment rate as low as 7.8%.

So stronger growth. per se, is no longer  a sufficient condition for a meaningful acceleration in price inflation in the Staff forecasts, with the path of inflation strongly influenced by the exchange rate ( with a quick pass through to import prices ) and the oil price ( energy accounts for about 10% of the CPI). Oil prices in the current forecast are expected to decline modestly over the next few years (based on the futures market) to $57 a barrel by 2020, but if they fell further, to say $50, annual inflation would be 0.2% lower in 2019 and 2020. On the exchange rate, the euro/dollar is forecast to be broadly unchanged at $1.17 but if it appreciated to , say,  $1.35 over the next few years it would reduce the forecast CPI  in 2020 by  0.6 percentage points.

The ECB’s forecasts could well be wrong, of course, and  inflation may pick up by more than expected but they highlight the risk of what could be a huge policy dilemma later this year.The Bank probably wants to call a halt to asset purchases for a variety of reasons but what if the euro does indeed appreciate and oil prices decline, so leading to lower forecast inflation? Awkward for a Bank that has argued that QE is crucial in getting inflation back up to target.

Irish real GDP now 50% above pre-crash peak

The volatility in Ireland’s quarterly national accounts has always been a feature and has increased of late, given the scale of the multinational influence on the headline data. The third quarter was no exception; real GDP rose by 4.2%, with the annual change at 10.5%,  leaving the average annual growth rate year to date at 7.4%.  Negative base effects would normally imply a marked deceleration in the final quarter ( the economy grew by 5.8% in q4 last year) and on that basis average growth for 2017 as a whole may well be around 6.5%, although given past experience anything is possible.

The  growth surge in q3 occurred despite a 13% plunge in domestic demand. Consumer spending rose at the strongest pace for some time (1.9%) and government consumption expanded by 0.7% but capital formation fell by 36%, with modest growth in construction ( 2%) dwarfed by a 22% fall in spending on machinery and equipment and a 60% decline in outlays on Intangibles. The latter largely comprises spending by multinationals on R&D and is particularly volatile (a 58% increase in the previous quarter) but is offset in the national accounts by service imports. That largely explains why  total imports  fell by 11% in q3, against a 4% increase in exports. Consequently net exports contributed a massive 16 percentage points to q3 GDP growth, which alongside a big stock build offset the negative contribution from investment.

Total merchandise exports exceeded €49bn in the quarter, against under €28bn recorded in the Irish trade data, highlighted the scale of contract or offshore  manufacturing. That export strength and the fall in imports contributed to a massive €14.5bn Balance of Payments surplus in the quarter, over 18% of GDP, with the surplus year to date at over €22bn.

On the headline data, Ireland’s real GDP in q3 is  now 50% above the pre-crash peak ( recorded in the final quarter of 2007) with exports having doubled. Consumer spending is only modestly higher, however, by 4%, while government consumption is still marginally below that previous high. It used to be argued that GNP provided a better guide to national income in Ireland but that too is 47% above the pre-recession level, with re-domicilled multinationals now impacting the amount of profit outflows. To give a better idea of underlying activity  on a quarterly basis the CSO have developed  a modified domestic demand metric, which seeks to exclude multinational R&D flows and the impact of aircraft leasing. On that measure domestic capital spending actually rose, by 5%, as did domestic demand, by 3%.

Annual growth in modified  final domestic demand  was 5.0% in q3, bringing the average over the first three quarters to 4.9%. which is much closer to the consensus GDP growth forecast for the year as well as being similar to the pace of expansion implied by the employment data. Yet, GDP is the standard measure of economic activity  and  barring a massive fall in q4  Ireland is likely to record a much stronger  growth figure  in 2017 than anyone envisaged.

Irish Central Bank tightens mortgage controls

The Central Bank introduced macroprudential controls on Irish mortgage lending in early 2015 with a focus on Loan to Value (LTV) and Loan to Income (LTI). The controls are subject to annual review and were initially amended  in January 2017 with  another set of ‘refinements’ just announced , to take effect from 2018.The latter includes quite a significant modification to the way the LTI control operates and in our view represents a tightening of credit controls, although one does not get that impression from the Central Bank release.

Currently, 20% of Principal Dwelling House (PDH) lending can exceed the 3.5 LTI limit. Data released by the Central Bank  shows that  PDH lending for the first half of 2017 amounted to €2,770m and that €487m exceeded the limit, or 17.6%, indicating that the limit is being observed, at least for that six month period  (  it  actually applies over a  full year).  Yet the data reveals a marked divergence between FTB’s and other buyers; over 24% of lending to the former was in excess of the 3.5 LTI limit, while for the latter the figure was only 10%.

Clearly the LTI limit is a much bigger issue for FTB’s in an environment of scarce  supply, strong house price inflation and where around half of house sales are going to non-mortgage buyers . As the controls currently stand there is no specific constraint on the amount of  FTB lending in excess of the LTI limit , as long as the overall lending figure is within the 20% exemption.

The Central Bank has responded by amending the LTI exemption. From January the overall 20% limit no longer operates, with  a 20% exemption  limit allocated to FTB lending and 10% to other lending. Had these applied over the first half of the year FTB lending would have been €61bn lower, with no material impact on other lending.

Just over half of PDH lending is currently to FTB’s so the implication is that there is now a 15% overall exemption limit in practice, given a 20% allocation to FTB’s and only 10% to other buyers. The Central Bank argues that FTB lending is less risky than to second or subsequent buyers ( although credit agancies seem to have a different view) , so justifying differential LTV’s and now LTI exemptions, but the changes would appear to mask an effective tightening in overall lending standards. The Bank notes that ‘the refinement is not expected to have a significant impact on the functioning of the market’  but it clearly will limit overall exemptions relative to the  current postion.

The US yield curve and the next recession.

The current US  economic expansion started in July 2009 and is already  much longer than the post-war average, although still  below the 10-year record duration set in the 1990’s, while closing in on the no.2 spot, set at 106 months in the 1960’s. A near term downturn is not inevitable but history suggests is likely at some point over the next few years. Forecasters are  poor at predicting recessions, and so there is interest in other potential signals. Equity markets generally turn down ahead of the real economy but they can and do fall without that precipitating a decline in GDP, so there is a risk of a false signal. The relationship between short term interest rates and long rates  (the yield curve) is another indicator of note, and in the US has proven  remarkably accurate ahead of the last seven downturns. Specifically, a yield curve inversion ( 10 year yields below 2 year yields or as some prefer, 3- month rates) has proven to be an excellent signal of a US recession a year or so ahead.

Why the success as a signal? Longer term  bond yields  carry a risk premium and are therefore generally higher than short rates, and may also be influenced by specific demand/supply factors at different maturities. For example, banks generally buy shorter term bonds, while pension funds seek much longer maturities. Expectations about the path of short term rates over the period are the most important factor, however, which in the US amounts to expectations about the Fed’s monetary policy and inflation. If policy is tightened in response to a booming economy or above target inflation longer term rates tend to rise, albeit by less than the move in short rates (the curve flattens) and may eventually invert if the market believes that  short rates have peaked and will eventually start falling . The inverted yield curve may also help precipitate a downturn because it dampens margins for the banking sector (banks borrow short and lend long)

The US yield curve is not currently  inverted but it has flattened appreciably; the 2-10 year spread has fallen from a peak of 260 basis points in late 2013 to just under 60 now, having started the year at 135.The recent pace of flattening has prompted much market debate  particularly as short rates are still very low by historical standards.

The Fed is  widely forecast to raise short rates again as early as December , and has signalled that it expects to tighten further in 2018, yet  10-year yields have fallen in absolute terms over the past month and are well below the highs in yield recorded earlier in the year.Maturing Treasuries are no longer being fully reinvested and, all things equal, the Fed’s decision to steadily reduce its holdings of bonds might be expected to push yields up. Some argue that issuance is shifting towards  the shorter end of the yield curve, so supporting longer dated paper, which in any case is still in strong demand as a ‘safe’ asset and  such assets are relatively scarce as central banks elsewhere are still buying.

A bigger factor may simply be that the market is convinced, at least for now, that  US inflation will continue to disappoint the Fed and remain below the 2% target, so implying that short rates will not rise to the extent the FOMC expect. The current  core inflation rate is only 1.3% ( the consumption deflator ex food and energy)  and was last (briefly) above 2% in early 2012. Most Fed governors believe that inflation will eventually start to accelerate as wages belatedly respond to the extremely low unemployment rate, but that view is not universally shared. Indeed, the minutes from the most recent FOMC meeting point to growing doubts as to whether sub-target inflation is indeed ‘transitory’.

Yield curve models are currently giving a low probability of recession in 2018 it has to be said ( the New York Fed’s model indicates around 10%) but the yield curve certainly bears watching given the recent trend.


Strong new mortgage lending but cash still king in housing market.

The number of new loans for Irish  house purchase topped 8,000 in the the third quarter , according to new data from the BPFI, the highest quarterly total in nine years, with the value figure of €1.8bn also the strongest since late 2008.The average new loan is now €221,000, which is substantially above the €170,000 cycle low recorded in 2013, albeit still well shy of the pre crash peak in excess of €280,000. In fact new lending is  also finally offsetting debt repayment and net mortgage lending  turned positive in the quarter for the first time since early 2010 according to figures from the Central Bank.

So the current housing cycle has been unusual in that it has occurred against a backdrop of  an overall contraction in  credit. Moreover, new lending for house purchase still appears to be accounting for only  50% of housing transactions; the CSO data base shows around 15,500 transactions (filings) in q3, which is almost double the number of mortgage drawdowns. The year to date figures reveal a similar picture, with 20,716 new loans for house purchase set againt over 43,000 in turnover, implying that over 52% of transactions are either cash buyers or have access to a credit source other than Irish mortgage lenders.

The approvals data also suggests that mortgage buyers are being squeezed in the market; approvals  for house purchase exceeded 20,000 in the six months to end- Sept but less than 15,000 were actually drawn down, an unusually low ratio. So potential buyers may be being outbid by investors amid general excess demand. The CSO’s monthly residential price index would certainly indicate that upward pressures are still very much in evidence; annual  house price inflation nationally accelerated to 12.8% in September and 13.2% excluding Dublin. Price inflation in the capital is re-accelerating again after a softer period last winter and the 12.2% annual increase in September brought the total rise from the cycle low to 87%.

Prices nationally are up some 70% since the low in early 2013 and the average new mortgage  has risen 30% in that period, again implying that credit has not been a significant factor in driving the market. Indeed, it would appear that the Central Bank’s mortgage controls have certainly not had a material impact on house prices overall, given the influence of non-credit factors, although they may well have impacted expectations around the announcement period.As we have argued elsewhere  (http://danmclaughlin.ie/blog/qe-is-fuelling-irish-house-prices/) the broader financial backdrop, notably the ECB’s asset purchase programme , has impacted the market by pushing down the rate of return on alternative assets and boosting investor interest in property markets.

Irish Misery Index on rise after all-time low

Irish consumer sentiment, as captured by the KBC/ESRI monthly index, reached a record high early in 2016 before slipping back later that year.It has picked up again in recent months and is now close to the previous peak. Households would therefore seem to feel good about the economy and their own financial situation and an alternative measure, the Misery Index, tells a similar story.

That is simply the sum of the unemployment rate and the inflation rate, two readily available monthly indicators that are likely to have a strong impact on the average household. The index fell to around 6 in 2004, reflecting an unemployment rate of 4.5%, and soared to a high of 18 in 2011 amid a collapse in employment.

The steady fall in unemployment in recent years has been the main driver of the decline in the index, which fell to an all-time low in June of 5.7%, with inflation at -0.4% and unemployment at 6.1%.The latter has fallen further, to 6.0%, but inflation has turned modestly positive so the index is now rising again, albeit still at 6.3%.

The Misery index has probably bottomed in this cycle, however, given the likely trend from here in inflation and unemployment. The latter may find it difficult to fall much further as the recent data implies we are at or near full employment; it has taken five months for the unemployment rate to fall from 6.2% to 6.0%.

Inflation may well see the sharpest change. Falling energy  prices and lower mortgage rates were big factors in dampening the CPI over the past three years but energy costs  have now started to rise again on an annual basis and mortgage costs are now unchanged on a year earlier.  The euro’s appreciation against  Sterling has proved a significant  counterweight over the past year, reducing the price of imported goods, notably food, but that will not be repeated absent another lurch down in the UK exchange rate.

Consequently, we may well have already seem the low of the cycle in the Misery index, although the increase may well be at a modest pace.