Mortgage Controls, the ECB and the Irish Housing market

Ireland’s monetary policy is set by the ECB and has had a very significant impact on household income and wealth in Ireland over recent years, as well as a profound effect on the housing market, particularly in relation to house prices and the ownership of the housing stock. Yet little attention is paid to it, in contrast to say Germany where it is heavily criticised and indeed the subject of legal challenge.  Similarly, the Central Bank introduced mortgage controls five years ago ,which again has had a material impact not only on housing but on credit growth, the distribution of wealth in Ireland and indeed on the political landscape, begetting policies designed to mitigate the consequences of these  monetary and macro prudential decisions.

Let’s start  with the controls. The average new mortgage for house purchase peaked in 2008 at €270,000 and then plunged alongside house prices before  bottoming in 2012 at €174,000. Since then it has risen steadily, reaching €233,000 last year, which when related to  rising incomes and the much lower cost of a mortgage indicates that affordability is much improved and in fact is still better than the long run average.

Mortgage controls are designed to limit  household leverage, imposing a LTI limit of 3.5 ( with some exceptions) and the Central Bank acknowledged in 2015 that  one might expect this to dampen house price inflation, credit growth and also negatively impact housing supply. We do not know how the market would have developed in the absence of such controls but the Central Bank  made a stab at answering  in their recent Financial Stability Review , estimating that prices in the period to the first quarter of 2019 would have been around 20% higher, or 4% per annum, with PDH lending substantially higher, by some 40%.The Bank does not show an estimate for housing supply but if prices had been higher completions would presumaly have been stronger, although what is also clear  is that the longer term relationship between house prices and supply has shifted since the crash, in that house building  has been much weaker in response to the actual price changes observed than experienced in the past.

If housing demand exceeds supply prices and/ or rents will increase, with that split being affected by, inter alia, the growth in income for  would be buyers, the cost and availability of credit and the type of buyer in the market. So if mortgage lending would have been higher in the absence of controls  then  some would-be buyers are forced to rent or live at home if that is an option. This has thrown up the odd situation  where the average rent nationally in 2019 was around €1200 per month, while the average monthly payment on a new  FTB 25-year mortgage  was  €1076 i.e. the rental payment could sustain a mortgage of  €254,000 instead of the actual FTB average last year of  €227,000. Landlords are therefore taking on higher credit risk than banks, and the average LTI for  FTBs  is actually only 3.1, which may be too low in an economy where the cost of housebuilding is high and where the  average rental payment  would service a mortgage with an LTI of 3.5 . It also  looks very conservative compared to the UK, where the LTI  cap is  4.5, with a 15% exception on a rolling twelve month basis rather than a calendar year.Rental growth in the UK has also been much weaker than in Ireland.

The type of buyer has also changed. The introduction of mortgage controls  coincided (?) with the ECB’s decision to buy bonds under QE, which alongside negative rates has pushed  Government bond yields into negative territory, including Irish debt out to 10 years. That renders Irish residential rentals yields ( which appear to be above 5%) unusually attractive and so we have had an influx of institutional buyers into the market, which was not a feature of previous cycles. Since the end of 2014  institutional buyers have purchased a quarter of new housing according to the CSO data, rising to 33% last year alone, which is then rented, with housebuilders also now more inclined to pre-sell developments to institutional buyers rather than risk waiting to sell to individuals.

QE is designed to boost investment in assets other than bonds and so will push up house prices, but  at the same time the Central Bank controls have constrained   access to mortgages for households. That not only has implications for owner occupation but also wealth: gross Irish household wealth rose to €947bn in the third quarter of 2019, of which €545bn was in the form of housing, or €412bn net of debt.Wealth in Ireland is therefore disproportionately held in property and so the combination of controls and QE has and will have  broader implications for wealth in Ireland  and its distribution over time.

As to the future, QE is open-ended at present and the market is not priced for a return to positive ECB  rates for years so the yield on bonds is unlikely to rise sharply, thereby maintaining the demand for rental yield. Similarly the Central Bank appears happy with the mortgage controls as they are, albeit showing some concern about the profitability of Irish banks (too low, that is), and if change occurs it may be to move towards a debt service metric- the impact of a fixed  LTI limit on mortgage payments  when rates are 3% would be be very different if rates were 5%.

A demand shock could change everything ( rents fell by over 20% from 2008 to 2010) as indeed could a supply shock. That might be positive (an upside surprise in terms of house completions) but also negative – an extension of rental controls or a rent freeze would reduce the value of the housing stock and it would be a very unusual economic development if that encouraged more completions.

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.

QE is fuelling Irish House Prices

Irish residential property prices have risen 60% since the lows of early 2013 but  this cycle is investor rather than credit driven. Gross mortgage lending for house purchase has picked but the average new loan has risen by just 28% over the past four years, implying a fall the average loan to value ratio, while data on transactions (recently revised up by the CSO) indicates that mortgage loans  still appear to be accounting for less than half of turnover in the market. New lending is also now constrained by the Central Bank’s mortgage controls.Moreover, net mortgage lending ( i.e new lending minus repayments) has been falling now for over seven years, although there are recent signs that it may finally be bottoming out.

Nothing here then to indicate that credit is playing a strong role in driving prices and it is curious that little attention has been paid to the impact of the ECB’s monetary policy  on the housing market, and, more specifically, its  non-standard measures including the asset purchase programme. The latter, QE, is designed to boost bond prices and hence lower yields so that ‘ investors may choose to take the funds they receive in exchange for assets sold to the ECB and invest them in other assets. By increasing demand for assets more broadly, this mechanism … pushes prices up and yields down, even for assets that are not directly targeted by the APP’.

QE is generally perceived as having a significant impact on equity markets and it would be odd if it did not therefore impact other  asset markets, including property, and we  can readily  see this at play in the Irish data on transactions. In 2011, investors (here defined as Buy to Let individuals  plus non-household buyers) accounted for 16% of residential transactions rising to 24% by 2012 and averaging a third of the market or more since 2014.

The yield on ‘risk-free’ assets , such as Government bonds, plays a big role in investment decisions and so the plunge in Irish Bond yields has been  a very significant backdrop for the Irish residential and indeed commercial property market : 10-year Irish yields peaked at double digit rates in mid 2011 but really started to fall sharply following Draghi’s ‘whatever it takes’ speech in 2012, and fell below 1% , where they still reside, following the commencement of QE in early 2015.

In contrast, the gross yield on residential property ( average rent/ house price) has not declined significantly in our rental model, and is still at 4.8%, having peaked at 5.4% in 2013. The rental yield fell to  a low of 2.75% during the last cycle, and is still well above the post EMU average (4.25%) and of course extraordinarily high relative to the ‘risk free’ rate available on Irish bonds, let alone Bunds.

The scale of investor interest in Irish property is therefore not surprising given the yield on offer and  is unlikely to disappear any time soon. Higher bond yields would make a difference, no doubt, and in that context the future of QE plays a part; the ECB will soon decide whether to scale back its asset purchases or indeed cease any additional buying. Yet it is likely to reinvest the proceeds of maturing bonds for a while at least, therefore maintaining the stock of QE, so absent an inflation shock bond yields may well stay low by historical standards. If so investor interest in Irish property will continue to be a big driver of the market.

Eligible Irish bonds a constraint on extending QE

The ECB has flagged the possibility of adjusting its asset purchase programme (QE) to  boost economic activity and move inflation closer to target. At the moment the Bank is buying around €60bn of assets a month, with over €50bn in the shape of Government bonds, with the intention of continuing until at least September 2016. One practical concern regarding extending that timeframe  is the supply of eligible bonds and that may well become more of an issue in the Irish market as we move through 2016.

The nominal value of Irish Government bonds  currently outstanding is €125bn, with some €95bn falling within the maturity range eligible for QE (over 2 years and under 30 years). Bonds yielding below -0.2% are also excluded under the current criteria, which affects a number of countries, notably Germany, but not Ireland. The ECB can buy up to 33% of bonds issued, so that implies an Irish figure of  €31bn.

QE started in March and purchases in the Irish market have averaged €0.8bn a month, bringing the total to €6bn at end-October. Plenty of scope left, therefore, except that the ECB and the Irish Central Bank  already hold Irish bonds, and that figure is included in the QE calculation. The Central Bank  acquired €25bn of bonds as part of the Promissory note deal, with €7bn  maturing within 30 years. The ECB’s holdings arose from the Securities Market Program , which operated for a time in 2010, and amounted to €9.7bn at the end of last year. We do not know the current position or how many will mature over the next two years but from the average maturity (4.5 years) it would seem reasonable to assume that  €7bn would redeem after 2017 and hence fall within QE eligibility.

On that basis the ECB and the Irish Central Bank may own an additional €14bn of Irish eligible bonds, bringing the total to €20bn  when adding the QE purchase to date. Absent any other changes that would mean that the ECB could buy an additional €11bn, which at the current pace of purchase implies a maximum of 14 months, taking us to the end of December 2016 or just three months beyond the current timeframe.

On the face of it, then, the scope for extending Irish QE is very limited, although two factors are likely to give the ECB some leeway, albeit not a great amount. The first is additional supply from the NTMA, with perhaps  €10bn issued in 2016, which would boost the eligible bond total by that amount if over 2 years in maturity. That would allow €3.3bn in additional QE , an extension of four months.  In addition , the Central Bank is required to sell at least €0.5bn of its bond holding next year and any sales would leave greater room for ECB buying of bonds held by the market. On that basis Dame Street may well sell far more than the minimum.

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.