QE Legacy: big losses for Central Banks, big profits for commercial banks

Ben Bernanke one said that the problem with QE is it works in practice, but not in theory.The latter point, much debated in academic circles at the time, centres on the fact that QE was an asset swap -the Central Bank bought bonds, largely Government debt, which paid a fixed interest rate, and paid the commercial bank sellers a floating rate on the reserves created to finance the purchase. So, it was argued, it was a zero sum game, with either side of the swap gaining and losing at any one time depending on the interest rate cycle.

Central banks made large profits for years, because the rates paid on reserves were near zero and in the euro area were negative, falling to -0.5% at one stage. This allowed central banks in may cases to transfer a large portion of these profits to their respective governments.The flip side, for Euro banks in particular, was a big hit to their net interest margin, as they were effectively paying the ECB to deposit money , with reserves swollen by ongoing QE, then augmented by the PEPP operation.

The ECB initially argued that credit growth would offset the negative impact on NIM but eventually became concerned about the impact on banks , eventually introducing a long term loan to banks at a rate below the deposit facility rate (TLTRO III) ,amounting to a profit subsidy.

The onset of the tightening cycle has changed the profit/loss dynamic however. The ECB’s deposit rate, for example, has risen by 4.5%, to 4%, since July 2022, so Central Banks across the zone are now faced with paying out far more in interest than they receive on the bonds they hold, which in some cases carry a negative rate anyway. The Bundesbank’s annual results makes this starkly clear; their interest income in 2023 was €55bn against interest expense of €69bn and with staff costs and other expenses the loss would have been €21.6bn, had they not transferred €19bn from provisions and €2.4bn from reserves. So no transfer of profits to the German Government and another loss is expected this year, which will wipe out the remaining reserves, with losses carried forward until eventually offset by future profits.

The Irish Central Bank has already flagged the probability of losses, particularly as it was making large profits from the sales of its IBRC linked bonds but have now sold the full complement. The Bank still owns €67bn of Irish Government bonds acquired through PEPP and QE, receiving relatively low fixed rates, while currently paying 4% on the €90bn held by Irish banks in the deposit facility( or €3.6bn a year). In some years the Central Bank was transferring €2bn or more from its profits to the Exchequer (not much commented on, oddly enough) but that will be zero this year and no doubt for some time to come .

Strong recovery in Irish house prices in recent months.

Our expectation for the Irish housing market in 2023 was for a slowdown in annual price inflation rather than an outright fall in prices, based on the view that employment growth would continue to boost demand , albeit dampened by higher mortgage rates and the impact of inflation of real incomes, alongside a continuation of steady bank lending, supported by the easing of mortgage controls. That forecast has proved broadly right, although the last few months has actually seen a sharp pick up in prices, in Dublin and across the country.

The national price index, as published by the CSO, had shown modest monthly price increases over the summer but that changed in the final quarter, with prices rising by 3.6% in the three months to December. As a result the annual change in prices has accelerated again, ending the year at 4.4% . This is weaker than the 7.7% recorded in 2022 but represents a recovery from the 1.1% seen in August.

The Dublin market has been softer than elsewhere in the country, perhaps due to the interest rate impact on higher mortgage loans , and prices in the capital fell for seven straight months to May last year, with the annual inflation rate also turning negative. Again, though, prices picked up markedly from the autumn, rising by 3.8% in the final quarter, so pulling the annual change back into positive territory at 2.7% in December. House prices in Dublin City had suffered most, down by over 4% at one point, but again ended the year positive, at 2.9%.

The market excluding the capital proved more resilient, with prices still generally rising on a monthly basis, albeit at a slower pace than the previous year. The final quarter also saw stronger price growth, at 3.4%, and the annual inflation rate in December rose to 5.7% from a low of 3.3% in August. The Midlands (Laois, Offaly, Westmeath and Longford) saw the strongest price gains over the year( 7.9%) marginally outpacing the Mid West (Clare Limerick and Tipperary) with 7.6%.

Why the pickup of late? A key factor may be interest rate expectations. New mortgage rates in Ireland peaked in September and more borrowers are opting for floating rates on the belief that ECB rates will fall this year, Most borrowers still fix of course, but the prospect of lower rates no doubt helps boost buyer sentiment and Builder confidence. Consumer price inflation has also slowed , which means real incomes are now rising again after a significant hit over the second half of 2022 and the first six months of last year. Finally, the supply of new housing did rise last year , by some 3,000 to 32,700 but the housing stock per head of population is still falling,so absent a big employment shock demand will continue to outstrip supply.

Irish housing market Update December 2023

With a few months data still to emerge for 2023 it appears that the Irish housing market has performed broadly as we expected earlier in the year, with housing supply the main exception. We had shared the consensus view that completions would fall , following some weak commencement data in late 2022, but in the event the published completion figures have held up well, exceeding 22,000 in the first three quarters of the year, and we now expect a figure around 31,000 for 2023 as a whole , which would be the strongest since 2008.

Housing and mortgage demand in our model is strongly influenced by real income growth, with the change in employment a key driver. On that score the labour market proved very resilient, with employment growth likely to have averaged over 90,000 in 2023 or 3.7%. As a result household income growth was an estimated 7.5%, hence outpacing CPI inflation (6.3%) to give a modest rise in real incomes.

The strength of employment also supported mortgage demand despite a rise in new mortgage rates rates, to 4.22% at end -October from 2.60% a year earlier, with lenders finally passing on higher market rates after initially using the huge volume of excess deposits to absorb the ECB’s monetary tightening. We expect the number of mortgages for house purchase to emerge at 35.650, or 3% down on the 2022 outturn, with the average new loan rising by over 5% to €290,000 so giving total lending for house purchase of €10.3bn, marginally ahead of the previous year. Total mortgage lending, in contrast, is estimated to have fallen by €2bn, to €12bn, as a result of a collapse in switching.

The weaker growth in real incomes allied to higher mortgage rates was expected to lead to a fall in house price inflation, rather than an outright fall in prices, and that duly emerged; national house price inflation slowed to 1.1% in August, while Dublin prices were down 1.8% at that point. However prices have picked up momentum in the last few months and we expect Dublin prices to end the year in marginally positive territory, with the national index up 3%, against a 7.7% rise in 2022.

Expectations also play a role in the housing market and the perception that the next ECB rate change will be a cut may well be supporting the market now- it is noticeable that over 15% of new mortgage loans in October were at variable rates rather than the 5% or so seen in recent years. Policy measures also remain supportive, notably the Help to Buy scheme, while the Central Bank effectively admitted to a policy error by increasing the Loan to Income limit from 3.5 to 4. We also expect the supply of new housing to pick up further in 2024, to 33,000, and that should help to boost new lending for house purchase to 38,000, with a value of €11.5bn. Overall mortgage lending is forecast at €13.5bn.

Employment growth is expected to slow next year , which impacts housing demand, and with increasing supply we expect prices to remain subdued, rising by around 4% by end-2024. As noted , employment is a key driver in our model and if that were to fall the price and mortgage outlook would be very different.

Irish GDP to contract 2% this year with zero growth likely in 2024.

We had expected Irish GDP to contract this year, by just over 1%, but following the release of the third quarter national accounts we have revised down our forecast to -2%, with 2024 growth now projected at zero. The 1.9% fall in q3 GDP was the fourth consecutive quarterly decline , a sequence last recorded in 2009. and brought the annual contraction to -5.8%, with the final quarter unlikely to record a big rebound. Consequently the carryover into 2024 will also be negative and even with some growth through the year the average may well struggle to get into positive territory.

The path of Irish GDP has been set by multinationals for some time now and total exports have also fallen for four consecutive quarters, with some growth in services offset by large falls in merchandise trade. This appears to be related to two factors; a post- covid fall in pharma and organic chemicals, produced in Ireland, and a collapse in outsourced exports , largely made in China. As a consequence total exports in q3 were down an annual 9.8% and the October industrial production figures point to another big fall in q4. That starting point for next year means that even with some rebound, export growth may be zero or even negative again.

The weakness in multinational exports has also translated into slower growth in net profit and interest outflows so GNP, which adjusts for such flows, is growing and we expect a 3.5% rise in 2023. Official forecasts now tend to highlight domestic demand as modified to exclude the impact of certain multinational flows on capital formation and that metric too has been weaker than most expected, with zero growth over the first three quarters of the year. Consumer spending is growing, boosted by spending on autos and services, but construction spending likely fell in 2023 as a result of a decline in non-residential building, while domestic spending on machinery and equipment is also negative. We expect modified domestic demand to grow by only 0.6% but to pick up to 2.2% growth next year.

There has been some some better news on inflation, with a sharper than expected decline in November, taking the HICP measure down to 2.3%, with the average for the year likely to emerge at 5.1%. The latter could fall to 2% in 2024 absent another energy shock. CPI inflation is higher as it includes mortgage rates and that may average 6.2% for 2023 before falling faster than the HICP measure next year on the assumption interest rates have peaked.

Does the negative GDP figure matter, if largely multinational related and indeed to specific export sectors?. One impact will be on the debt ratio, which has tumbled in recent years as a result of the stellar rise in GDP but is now forecast to fall at a much slower pace given only a 2% rise in nominal GDP in 2023 -the ratio eases to 43.8% from 44.4% in 2022.The debt figure is also impacted by the Government decision to eschew a more rapid debt decline in favour of transferring surpluses to two new medium term funds to support future infrastructure spend and the impact of an ageing population on the Budget.

Weaker multinational profits could also have a major impact on the fiscal position given the importance of Corporation tax and that seemed to be materialising as as issue over the Autumn but a strong rebound in receipts in November implies the General Government surplus will emerge at around €8bn or 1.6% of our projected GDP. The Corporation tax rate is set to rise from 12.5% to 15% in 2024 and this should help to support receipts.

The most serious potential impact from falling GDP could be on the labour market but although there has been layoffs in the ICT sector overall employment growth is still rising at a rapid clip,up by 100k or 4% in the third quarter. The unemployment rate has risen, however, to 4.8% in November from 4.1% earlier in the year, but that reflects a further rise in the participation rate, with labour force growth now outpacing employment.That means the potential growth rate of the economy may well be higher than official forecasts indicate.Cracks in employment though would be much more significant than the recorded GDP figure because of its impact on household incomes, Government finances and the housing market.

Irish economy contracts for fourth consecutive quarter

Irish GDP fell by 1.9% in the third quarter according to the latest national accounts, marginally worse than the 1.8% flash estimate, the fourth consecutive quarterly decline, a sequence last recorded in 2009. The cumulative fall left the annual change in q3 at -5.8% , implying that our forecasts for a 1.2% average decline for 2023 now looks too optimistic.

Exports, long the driving force behind Ireland’s stellar GDP growth, have also fallen for four consecutive quarters, and are now down an annual 9.8%. Service exports have risen , up an annual 4.2%, so the issue have been on the merchandise side, with exports there down a massive 22%. Goods for export produced in Ireland are dominated by Pharma and Organic chemicals and weakness there appears to be related to a post-COVID drop off in vaccine demand. However the annual fall in merchandise exports produced here is €5.7bn against a €23bn plunge in overall merchandise exports, so a big factor is the collapse in outsourced exports, generally thought to be smartphone related and produced in China for an Irish based company.

The fall in multinational exports has had a knock on effect on profits and hence Corporation tax receipts while also impacting net profit outflows, which fell sharply in the the third quarter. As a result, GNP, which adjusts for these flows, grew by an annual 10.8% in Q3 and is likely to have grown strongly over the year as a whole.

Retail sales fell for a sixth consecutive month in October and consumer spending overall has been supported by services, with personal consumption rising by 0.7% in q3 and an annual 2.6%. Government consumption has slowed post the Covid related boost , rising by an annual 1.2%, although overall domestic demand is is much weaker, declining by an annual 5.6% , due to a big fall in capital formation. This is part reflects weaker investment from the multinational sector but construction spending and domestic investment spending have fallen. Consequently, modified domestic demand, the metric often preferred in official forecasts, fell by annual 0.4% in q3 following a 1.2% decline in q2, and is likely to grow by 1% at best over the full year, weaker than consensus expectations.

Normally one might expect such as sequence of GDP declines to have fed in to the labour market, and although the unemployment rate has risen from historic lows in the past few months employment to date is still growing strongly, as also reflected in income tax receipts. So the issue appears to be largely related to the multinational sector and to specific factors in Pharma and more importantly in China. As such the near term outlook is highly uncertain despite better news in other ares, notably the fall in inflation and the probability that interest rates have peaked.

2024 Budget: Spending and tax relief deemed more appropriate than faster debt reduction.

in April this year the Irish Government published medium term fiscal projections incorporating a cumulative General Government surplus of €65bn over the four years 2023-2026, prompting much comment as to how best to utilise those funds, although of course forecast rather than actual. Following the 2024 Budget that cumulative total is now €40bn, the reduction due to a combination of weaker forecast revenue growth, one-off expenditure and tax measures, cuts to income tax, transfers to a newly created medium term fund and stronger growth in core expenditure.

The economic backdrop forecast for 2024 in the Budget is fairly benign, in that real GDP growth rebounds to 4.5% from a projected 2.2% this year with the labour market remaining around full employment , albeit with weaker employment growth, while CPI inflation is projected to fall sharply to average 2.9% from 6.3%, so supporting real incomes. Modified domestic demand is forecast to match this year’s 2.2% estimate.

The pre-Budget White paper had projected an Exchequer surplus €3.5bn this year but that is now reduced to €2.2bn, as a result of additional one-off current expenditure on household energy credits and other cost of living supports. For 2024 the pre-Budget figures had projected an Exchequer surplus of €9.4bn and that is now €1.8bn. Tax receipts are €0.7bn lower as a result of Budget decisions with current expenditure up by €2.6bn and capital rising by €5bn including a €4bn transfer to a newly created Future Ireland Fund.

Is the Budget inflationary? Probably, although the inflation forecast does not imply a big impact.The economy is around full employment and ‘core’ expenditure rises by €5.3bn or 6.1%, with an additional €5.3bn in ‘non-core’, largely related to humanitarian assistance to refugees , as against a projected €4.3bn rise in tax receipts. Non-tax revenue also falls sharply from €2bn to €1bn, in part because the Central Bank surplus will disappear, although there is no provision for further sales of bank equity.The Central Bank is also unlikely to be thrilled by the Budget decision to give a one-off tax relief for mortgage holders whose interest payments rose in 2023 relative to the previous year.

What about Government debt? There the picture remains bright because the average interest rate on the debt remains remarkably low, at a projected 1.6% in 2024, while GDP is forecast to rise in nominal terms by over 7%, so even though gross debt is forecast to remain stable around €223bn the ratio to GDP falls to 38.6% from 41.4% in 2023.

Irish 10-yr bonds trade around 40bp over Germany and 20bp through France so the market does not believe Ireland has a debt issue, and on that basis the Government decided that the benefit to society of higher spending, tax cuts and a Future Fund is higher than a faster debt reduction.

Irish GDP growth to slow to zero this year and Fiscal outlook cloudier than appeared.

For some time now Irish exports have grown at a double digit pace, even during the Pandemic period, seemingly immune to cyclical developments in the global economy, and as such driving stellar growth in GDP, which averaged 9.2% a year between 2017 and 2022.. Chemicals and Pharma were key in that period, but there was also a remarkable rise in goods produced elsewhere but owned by Irish based entities and as such classified as an Irish export. These appear to be largely ‘machinery and equipment’ and generally thought to be semi-conductors for phones and made in China. The impact of this outsourcing is significant; in 2022 total Irish merchandise exports as per the national accounts amounted to €354bn, with goods produced here at €208bn or less than 60% of the total.

That long trend growth in exports came to a halt in the final quarter of last year and exports fell again in the first and second quarters. The fall in merchandise exports was particularly large in q2, at over 10% in the quarter in value and volume, so driving a 4.1% fall in total exports (including services) . Yet merchandise exports produced in Ireland actually rose marginally so the decline was due to outsourced exports, with goods for processing down €15bn or 58%. This may be company specific or due to issues in China itself and as such exports may rebound to some degree but that is uncertain and we have cut our export forecast to zero for the year.

We now expect domestic demand to contract by over 1%, with an 8% fall in investment spending offsetting growth in consumer spending and government consumption. Construction is forecast to fall by 3%, including a decline in housebuilding, with a 10% contraction in spending on machinery, equipment and Intangibles.The latter is strongly impacted by multinational R&D and is excluded from the CSO’s measure of modified domestic demand, which we expect to grow by 1.5%, supported by a 3% rise in consumer spending, which is considerably weaker than the 9.4% recorded last year, following a significant upward revision. The corollary was a significant downward revision to the savings ratio, although still running at a double digit pace.

Real pay per head is falling but aggregate real income for households is now rising again , thanks to the strength of employment growth. Inflation has been slower to fall than many anticipated, with the CPI measure at 6.3% for August. That is well down from the 9.1% peak but the fall was largely due to base effects from energy prices (although food inflation is slowing sharply) with service inflation now the driver, including a significant rise in mortgage costs, which added 1.4pp to the latest annual figure. Moreover fuel prices have started to rise again, so we expect only a modest fall from here to year-end and an annual average figure of 6.5%. The Government and the Central Bank now use the HICP measure in their forecasts, which excludes mortgage interest and is consequentially lower, and we expect that to average 5.6% this year. Both measure should fall gradually next year on base effects alone absent another energy shock.

We have emphasised for some time now that Ireland is at full employment, with the unemployment rate now trending around 4%. Employment growth has been strong, despite some high profile redundancies in part of the ICT sector, with a 78k rise on average likely this year, or 3.1%, broadly matched by a similar increase in the labour supply. That strength has been crucial in preventing a sharper correction in the housing market and in mortgage lending for purchase than seen to date, despite the rise in mortgage rates, and helped support tax receipts, with income tax up an annual 8.2% in August.

That heading is slowing though as indeed is tax revenue overall, to 6.6% in August from double digit growth rates seen earlier in the year. Some headings are flat (excise duty,impacted by the cut on fuel duty) and others well down on the year, including capital taxes and stamp duty ( affected by weak commercial property sector). VAT is still strong, rising by over 11%, but again is slowing, no doubt impacted by the fall in inflation. The big change though is in corporation tax, which is still well ahead of last year , by over 7%, but was growing by over 50% at one stage. One might expect the weaker export performance to eventually feed through to multinational profits and in that sense some softening is to be expected.

The upshot though may be that the Budget surplus expected this year could be lower than expected. Moreover the €65bn cumulative surplus flagged in April over the period 2023-2026 may not emerge as predicted, due to higher spending than initially projected and to some softening in receipts, including no transfers from the Central Bank. which will probably record losses.Employment growth too is likely to slow with a knock-on effect on income tax receipts and VAT.

Consumer boom has driven Irish inflation

The CSO has just published revised national accounts for the the Irish economy. The initial 4.6% decline in real GDP in the first quarter of this year has been revised down to -2.8% , thanks in large part to a smaller fall in exports than initially thought, but the most interesting aspect of the new data relates to consumer spending . It now transpires that we have been experiencing a consumer boom which also helps to explain why Irish inflation has remained stubbornly high.

Consumer spending in 2022 is now put at €133bn, which is €10bn higher than previously published, with 2021 also revised up,this time by €6bn. In volume terms personal consumption grew by 8.4% instead of the initial 6.6%, with 2021 now put at 8.4% from the original 4.6%. In other words real consumer spending over the past two years rose by 18.6%. As a consequence modified domestic demand ( which includes government spending and investment adjusted for multinational investment flows) is now seen to have risen by 17.5% instead of the initial 14.5%.

Consumer spending had fallen in 2020 because households could still buy goods but not a a range of discretionary services and it is spending on the latter which grew very rapidly last year.Spending on food and alcohol fell in volume terms but spending on restaurants and hotels rose by 27%, with a similar rise in spending on recreation and culture while spending on foreign travel rose by a massive 248%.

The most recent inflation data, for June, highlights the impact that spending has had on the price level in Ireland. The annual inflation rate is certainly slowing, down to 6.1% from a peak of 9.2% last October, but that largely reflects falling energy prices. Indeed the core inflation rate , which excludes energy and fresh food, is actually rising, hitting 7.1% in June.

Goods price inflation in Ireland is now just 1% while services inflation is 10.3% so it is the latter now driving the overall inflation rate. This does reflect higher mortgage rates ( adding 1.3 percentage points to the total) but the rebound in spending on the discretionary services noted above is clearly apparent in the CPI data: inflation in package holidays is 43%, airfares are up 34%, hotels are up 13% with restaurants at 6.6%.

The growth in consumer spending is slowing, to an annual 5.1% in the first quarter, and that would appear to be necessary if inflation is to fall back to the levels forecasters expect.

Irish GDP contracts by 4.6% in First quarter

The Irish economy contracted by 4.6% in the first quarter, a much steeper decline than the flash estimate of -2.7%. The scale of the fall allied to a massive base effect (GDP had risen by 7.9% in the first quarter of 2022) pushed the annual growth rate into negative territory at -0.2%.

The headline figure in the Irish national accounts often masks a wide disparity in the performance of the indigenous and multinational sectors and this was the case in q1, although for a change it was the former that outperformed. Consumer spending rose by 1.7%, boosted by strong auto sales, with construction spending increasing by 8.7% while investment in machinery and equipment excluding aircraft leasing jumped by 16%. Government consumption did fall, by 3.5%, but overall final modified domestic demand grew by 2.7% and by an annual 5.5% which is more consistent than GDP with the very strong employment data seen this year.

The fall in GDP was largely due to a 2.1% fall in exports with merchandise exports down 4.6%. This reflects a fall in contract manufacturing (offshore production for Irish based entities) and may relate to a certain mobile phone company’s issues in China.Imports also fell, by 2.2%, but in this case it was due to a decline in service imports, reflecting weaker spending on R&D and royalties. This is also captured as investment spending on Intangibles and this duly fell sharply as well , by 36%, which also explains why overall capital formation fell by 12.7%.

It is also worth noting that the fall in the quarter is much larger than the component parts would imply, due to a large change in the statistical adjustment figure and as such may be revised.

Why isn’t inflation responding to ECB interest rates?

The ECB’s latest rate increase brought the Deposit rate to 3.25% and the cumulative tightening to 375bp over the past ten months. In addition the Bank has also taken steps to reduce the size of its balance sheet and the degree of excess liquidity it is pumping into the euro banking system and from July will stop reinvesting any proceeds from maturing bonds bought under QE. Yet although headline inflation in the euro area has fallen from a peak of 10.6% to the current 7%, that largely reflects base effects from energy prices, with core inflation at 5.6% and showing no clear signs of easing.

The ECB’s policy actions have had a clear impact on credit and the housing market, both through the effect of higher rates on borrowing costs and via a substantial tightening in credit standards from the banking system-indeed the past six months has seen the sharpest tightening since the financial crisis. Yet although the ECB still expects inflation to fall it is clearly concerned about core inflation and noted in its recent monetary statement that in relation to their rate increases ‘ the lags and strength of transmission to the real economy remain uncertain’.

That uncertainty is highlighted in the ECB’s latest Economic Bulletin in a piece setting out the impact of higher rates as captured across three economic models used by the Bank. In one respect it is reassuring for the Governing Council as it shows that inflation does fall substantially in response to higher rates when using the average effect across the models, with the largest impact in 2024 and 2025. It takes time therefore for monetary policy to work, although the BoE and the Fed tend to highlight lags more than the ECB in policy statements.

However, the models also show a surprising large variation in how rates affect inflation and the real economy, highlighting the uncertainty surrounding monetary policy in the current environment, where inflation has been driven by supply shocks rather than a credit boom and where a high percentage of existing loans in many countries are at fixed rate. One model, for example, shows inflation falling by 0.8% next year, with another showing a much larger 3.5% fall . The latter also shows a 3.5% fall in real GDP in contrast to the former’s 1.75%.

One result of that uncertainty about the impact of monetary policy transmission to inflation is that the ECB appears to be putting far more emphasis on ‘the incoming economic and financial data (and ) the dynamics of underlying inflation’. So the latest inflation data has a big impact on policy rather than any staff projections of inflation in the future. This raises the risks of a policy error (i.e. tightening by too much and causing a large rise in unemployment ) particularly as the bank claims to be both data dependent but with ‘more work to do’ . At the time of writing the market is priced for rates to peak at 3.75% , or another two quarter point increases , but the majority of Council members would want to see clearer signs that core inflation is on a downward path before becoming comfortable with the idea of that rate as the peak.