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.

Irish Mortgages and ECB rates

The ECB largely controls short term interest rates in the euro money markets, but the feed through from there to retail rates in each member state is also influenced by a range of other factors, including local banking conditions and competition. That country effect is clear from the latest figures on new mortgage rates at end-March, with a range from 2.3% to 5.4% around the average of 3.52%.

That average figure is 206bp up on the year and only reflects the change in ECB rates to February, which at that time was 300bp. Rates rose by a further 50bp in late March and by 25bp last week , so the full impact of monetary policy changes has yet to be felt.

In Ireland, the ECB tightening cycle has not to date had a major impact. New mortgage rates actually fell for most of 2022, and although rising sharply in March, by 62bp to 3.54%, still left the annual change at only 76bp, well below the norm elsewhere, with rates here now the third lowest in the EA, having been for years the highest.

Why the muted rate response here, which is all the more surprising given that two of the five main bank mortgage lenders have left the market?. The answer is twofold. One relates to the cost of funding for the remaining Irish banks, which has been dampened by huge amounts of household deposits in the banking system, standing at €151bn from under €100bn five years ago.Most are in current accounts, classed as overnight deposits, and pay virtually zero interest (0.03%). Of course the banks could have raised those deposit rates (and rates on longer term deposits are starting to inch higher) but deemed it unnecessary given the scale of excess deposits in the system( deposits exceed loans by €74b). Banks had also lost some market share to non-bank lenders, largely dependent on market funding, so utilised the competitive advantage on deposits to undercut the non-banks and regain market share. In effect, households with deposits have been subsidising new mortgage borrowers.

The ECB impact on existing loans has also been muted. The average mortgage rate on outstanding PDH loans was 3.20% in March, having risen by 74bp over the past year. Again that is low relative to the change in ECB rates, reflecting the high and growing share of fixed rates; 65% of outstanding PDH mortgage are on a fixed rate, a far cry from the position a decade ago, with less than 10% fixed.

Standard variable rates have risen , albeit modestly to 3.54%, but the biggest impact was felt in Tracker rates, linked to the ECB refinancing rate, with the average in March at 3.47% . The Tracker spread is around 1.1% so the current refi rate of 3.75% implies a Tracker rate of 4.85% over the next few months and a possible cycle high of 5.35% if current market expectations are borne out.

The Tracker mortgage share is falling steadily as new fixed loans replace maturing Trackers,and now amounts to 22% of outstanding PDH loans, which in round numbers equates to 130,000 mortgages with Irish banks. These borrowers have benefited from low ECB rates for the past decade, paying only around 1.1% for most of that time.

These published mortgage rates from the central bank relate to bank loans only, and 114,000 or 16% of mortgages are held by non-banks, where monthly reporting is not available. The central bank has just published an update, however, showing the average rate is 3.97%, so well above the 3.20% bank average. The percentage of fixed loans is much lower than the bank equivalent, at 31%, and this largely explains the differential, with standard variable rates much higher, at 5.12%% versus 3.64%. A third of non-bank mortgages are Tracker, again well above the Bank figure, or some 37,000, although the rate is actually slightly lower , at 4.25%, than the 4.37% paid by bank Tracker holders.

A very diverse picture then on mortgage rates, both across countries and within Ireland. New borrowers here have been sheltered from the full impact of tighter ECB policy by the scale of household deposits, while the impact on existing borrowers has been dampened by the high percentage of fixed loans. The losers have been those on Tracker rates, with more pain to come, albeit having benefited for years ,but the relatively low numbers involved ( 140,000 out of a total PDH figure of over 700,000) means that to date higher ECB rates have not had a big impact on the Irish economy,or indeed on underlying inflation, which is in theory the rationale behind the ECB’s actions.

Irish GDP grew by 27% over last two years

Irish GDP grew by 12% in real terms last year, following a 13.6% increase in 2021, and the average figure over the past six years is an extraordinary 9.1%. The spike in inflation in 2022 also boosted nominal GDP, which rose by 17.9% , to €502bn, from under €300bn as recently as 2017.

Exports have been the key driver of that stellar growth although the net export contribution in 2022 was more modest, boosting GDP by 2.5%, with investment spending the main engine last year, contributing 7.5%. Capital formation in total grew by 26%, including a strong performance from construction ( 10%) with a 45% surge in housebuilding. Spending on machinery and equipment also had a strong year, up 29%, with Intangibles rising by 34%. The latter is extremely volatile (it fell 57% in 2021) as it is strongly influenced by multinational spending on intellectual property and R&D, and also captured as a service import, and therefore broadly GDP neutral.

Despite the rise in inflation last year (the CPI increased by 7.8%) real consumer spending rose by 6.6%, which was the strongest increase since 2007. Real government spending growth was a modest 0.7% , following the pandemic related increase over the previous two years, while stock building was very strong, adding over 2% to GDP. GNP, which adjusts for the net international flow of profits and interest, grew by 6.7%, following a big rise in multinational profit outflows, although again over the past two years the increase in GNP is over 20%.

The CSO also produce an estimate of final domestic spending (i.e excluding all foreign trade and stock building) adjusted for the impact of aircraft leasing and multinational spending on intellectual property, and this modified domestic demand figure grew by 8.2%.

The quarterly breakdown shows the economy slowing in the second half of the year, with GDP growing by just 0.3% in the final quarter. Export growth eased substantially, to 0.4%, but the main factor dampening the GDP figure was a 46% plunge in investment sending. This also depressed imports,so avoiding a fall in GDP, and reflected declines in construction , spending on machinery and equipment and intangibles, the latter extremely large at 62%. As noted this component is volatile (it rose by 91% in q3 for example) and is likely to be the main factor behind the large revision to the q4 data, as the CSO had initially announced that GDP had risen by 3.5% in q4.

That estimate captured international attention because it added 0.1% to the overall euro GDP estimate but that now disappears, which alongside a downward revision to the German data for q4 (now put at -0.4%) means that the euro area may well have contracted after all in q4. From an Irish perspective the softer than expected final quarter will impact growth estimates for 2023, although the carryover effect is still very strong, with annual growth in q4 at 12%.

Housing Market Update: softer tone

Rising interest rate, falling real incomes and tighter credit standards have led to a turn in the international housing cycle, with the long boom now giving way to a slowdown, most notably in the US, although in most countries that as yet has not translated into large nominal price falls.

In Ireland, prices nationally are still rising but at a much slower pace; by 0.8% in the three months to December, compared to 3.4% in the same period of 2021. As a consequence the annual increase in December slowed to 7.8%, compared to 15% in the early months of the year.The trend has not been uniform across the country, however, as prices in Dublin actually fell in the final quarter, albeit by a modest 0.6%, leaving the annual change at 6%, against a figure of 9.3% elsewhere in the country, although double digit gains were recorded in the West ( 14.9%) and the Border counties ( 11.5%). .

One factor in the softer price tone was a marked increase in housing supply, with completions emerging at just shy of 30,000 in 2022, a substantial rise from the 20,000-21,000 totals seen in recent years.This also helped to boost mortgage draw downs for house purchase, increasing to 36,800 from 34,500 in 2021.The average purchase mortgage rose by 10% , to €276,000 , so boosting the total value of purchase mortgages to €10.2bn from €8.6bn the previous year. Headline new mortgage lending came in at €14.1bn , inflated by a very significant rise in switching, although the latter has no impact on housing demand nor indeed net mortgage debt. In fact the latter fell in 2022 by €700m or 0.9%, and the absence of credit growth perhaps best explains why the Central Bank eased its mortgage controls, increasing the LTI for FTB’s to 4 from 3.5.

That credit contraction alongside the huge level of household savings in Ireland left the domestic banks here with deposits exceeding loans by €89bn. As a consequence new mortgage rates only started to rise in December, five months after the first ECB rate increase, leaving Irish rates well below the EA average ( 2.69% versus 2.95%) and now the third lowest in the euro area.

The average rise in house prices in 2022 (as opposed to year-end) was 14.2% which was reasonably close to our model forecast rise of 12%. The biggest demand factor for housing is real household income and that fell last year, albeit by not as much as many anticipated it would seem (the final quarter figure has yet to be published) boosted by strong employment growth. This year will probably see a big fall in inflation so we expect a broadly flat income figure. which would be more supportive of demand. On interest rates most models tend to use the real mortgage rate , which fell sharply last year given the surge in CPI inflation, but we find the nominal rate is better supported empirically. On that basis the market is currently priced for another 1.25% from the ECB which may not all feed through to retail here but the likely increase is a negative factor for demand.

Affordability on our model deteriorated in 2022, reflecting the rise in the average mortgage, but was still below the long run average due to the offsetting impact of rising nominal incomes and lower interest rates. That changes this year, given the rate outlook, and affordability is forecast to be worse than the long run average for the first time since 2009.

Housing supply enters our model with a lag so the 2022 increase acts to dampen price growth in 2023, although we expect house completions to fall back to around 26,000 through the year, which would be supportive in 2024. That anticipated fall in supply also affects our mortgage forecasts, with new purchase loans falling to 32,500, with the value figure also falling to €9.4bn, although switching may boost the headline figure to €14.4bn, marginally above the 2022 out turn.

Expectations also play an important role in the housing market, both from buyers and developers, and that is difficult to capture in a formal way. We prefer adaptive expectations (ie. the recent price trend determines current expectations) but shocks to the economic or political outlook can materialise ( another sharp rise energy prices for example, or a larger rise in unemployment than we expect) but absent shocks we expect an average price rise in 2023 of 5%, implying a continued slowdown through the year to around 2% by December.

Double digit growth again for Ireland in 2022, 5% next year

Following the release of National Accounts for Q3 Ireland looks on course to record double digit real growth for 2022 as a whole: the annual average year to date is 11.7% and we now expect a figure of 12.4% for the full year.Moreover, thanks to higher inflation nominal GDP is likely to rise by 17% to over €500bn, from €175bn a decade ago.

Real GDP grew by 2.3% in the third quarter, following modest upward revisions to growth in the first half of the year, now put at 2.2% in q2 and 7% in the first quarter. Exports again performed strongly,. increasing by 4.8%, although this was dwarfed by a 27% surge in imports., albeit largely due to a massive increase in service imports, in turn captured by capital investment in intangible assets by the multinational sector. As such this is broadly neutral for GDP (the investment boost offset by higher imports) but is extremely volatile, not only quarterly but also in the annual data.

Capital formation actually fell in the quarter when adjusted for this multinational effect, declining by 4.6%; construction spending fell marginally but there was a 7.2% fall in investment in machinery and equipment. This was the main factor behind a 1.1% contraction in modified final domestic demand, with personal consumption barely rising (0.3%) and government consumption recorded a modest 0.3% fall.

In fact personal consumption looks to have held up well through the year , despite the hit to real incomes caused by much higher CPI inflation , largely due to robust growth in nominal disposable income, which may average over 7% in 2022, boosted by strong employment growth. We expect 6% consumption growth in 2022 and the savings ratio , although moderating, is higher (over 19% average ytd) than most expected as a result of the income growth.

We have revised up our capital formation estimate for the year as a result of the q3 outcome and now expect a rise of 23%, with a 9% increase in construction spending and a 28% rise in machinery , equipment and intangibles. The latter is also reflected in an upward revision to our import estimate, but exports too are stronger than we initially envisaged, and we now forecast a 14% increase in that component. Consequently the external sector is again the main driver of Irish GDP growth , with that export performance offset to some degree by higher multinational profits outflows, so reducing GNP growth to a forecast 8%. Modified final domestic demand is estimated to rise by 6.5%, with the recent slowdown offset by a strong carryover impact earlier in the year.

GDP growth is much stronger than earlier consensus estimates and Ireland’s fiscal position is also much more robust than initially envisaged by the Government; the 2022 Budget projected a €7.7bn Exchequer deficit , predicated on 2.6% growth in tax receipts, but by end-November the Exchequer had recorded a €14bn surplus, with receipts up 25%, with all the major tax headings well ahead of expectations. In response, the Government has put €2bn into the Reserve Fund, so reducing the surplus to €12bn. Corporation tax was expected to fall but is over 50% up on the previous year, maintaining a pattern of underestimation evident for the past decade. Ireland’s debt to GDP ratio will probably end the year below 45% and 10-yr bond yields have been trading around 45bp over Germany and as such below France and Belgium.

Inflation in Ireland may have peaked at 9.2% on the CPI measure in October, with falling fuel prices the main disinflationary factor, although the average for the year is likely to be around 8%. We expect a steady decline through 2023 with the average next year at 4.6%. This will again dampen real income growth , particularly as employment and labour force growth is slowing given the scarcity of labour, which has pushed the unemployment rate below 4.5%. We expect very modest employment growth next year and a modest rise in the unemployment rate to over 5%, and as a result project only 2% growth in real consumer spending for 2023.

House completions may surprise to the upside this year (we expect 29,000) but look on course to decline in 2023 given some of the forward indicators and we also expect total construction spending to fall by 8%, contributing to an overall 4.5% fall in capital formation, although the intangibles component can always spring a surprise. Consequently we expect modified final domestic demand to grow only marginally, by o.5%. GDP growth as a whole will again be largely determined by the export performance, which in truth seems impervious to global demand ; the annual change in exports is still strongly in double digit territory so even even with little growth through the year the average export figure for 2023 is still likely to be 8%. That assumption helps deliver GDP growth of 5%, with GNP increasing by 4%.

Housing Market Update

Following the release of recent data on housing supply, mortgage lending and residential prices we have updated our models and forecasts for the Irish housing market, including projections for 2023, summarised on the website.

We are revising up our estimate of house completions this year, and now expect a figure around 29,000, which if broadly right will be the strongest supply figure since 2008. Annual completions have been in a 20,ooo-21,000 range for the past three years and as such well below the 33,000 figure deemed by the Government to represent annual demand. Completions this year have picked up and the 7,500 figure for q3 brought the four-quarter total to just shy of 28,000, prompting our upward revision. Some analysts had reduced their completions forecasts earlier in the year, in response to the surge in housing construction costs, but that is more likely to impact supply next year.

We have also revised up our estimate for new mortgage lending. For house purchase we expect 36,500 new loans, 6% above the 2021 figure,and again another 14-year high. The double-digit rise in house prices is reflected in much higher average mortgages, and we expect that figure to be around €279,000, up from €250,000 in 2021. The resulting total figure for house purchase is €10.2bn against €8.6bn last year. Total new lending has been boosted by very strong growth in switching, which amounted to a third of mortgage loans in the third quarter. This has no effect on net lending, nor on the housing market , but is substantial now, and we expect total lending this year to rise by €4bn, to €14.3bn.

House prices are still rising but at a slower monthly pace than last year, so the annual inflation rate in residential prices is slowing, to 12.1% on the latest CSO figure (for August) from a high of 15.0% in February. We expect this trend to continue, with a December forecast of 8.0%. This would give an average figure for the year of 12.5% which is in line with our model forecast- falling real incomes act to dampen prices but offset by strong price momentum, low interest rates and the lagged impact of weak supply,as the growth in the housing stock has not kept pace with the growth in population.

The interest rate impact this year has been surprising, in that the average new mortgage rate has actually fallen since the turn of the year, despite the significant rise in market rates, which has led to significant increases elsewhere; the average new rate in the EA in September was 2.40%, 111bp higher in the year, against 2.58% in Ireland, which is 11bp lower.Consequently, although affordability has deteriorated in response to the rise in the average new mortgage it is still below the long run average on our affordability model.

Expectations play an important part in short term house price movements, albeit hard to adequately capture in modelling, and there is a risk that prices weaken more than we expect if potential buyers decide to postpone purchases given uncertainty about the outlook for inflation, employment and interest rates. On the latter we expect new mortgage rates to start to climb soon and so affordability deteriorates in 2023, to above the long run average. However, inflation is expected to slow and absent a big employment shock real household incomes will be broadly unchanged after a fall this year. On the supply side the recent commencement data points to a weaker supply total next year, and we expect completions of 25,000. This is supportive of prices but we still expect a further slowdown, with a 2% annual end-year rise expected in 2023 .New purchase mortgage lending will also slow, to €9.5bn, with the total figure ( i.e. including switching) marginally higher than 2022, at €14.5bn.

Irish mortgage rates and ECB rates

The ECB began to raise its main lending rates in July , followed by another round of increases in September with a further set expected at the October 27th meeting.The impact on Irish mortgage borrowers has not been as straight forward as many anticipated ; existing borrowers with Tracker rates have seen a significant rise but the average new mortgage rate has actually fallen this year, reflecting both specific Irish liquidity issues and an unusual set of factors affecting the pass through of ECB rates to the Euro money market as a whole.

Half of the outstanding mortgage loans of Irish banks are at a fixed rate so those borrowers will be unaffected by money market changes, at least in the short term. In terms of variable rates 60% of those borrowers (and so 30% of all borrowers) are on Tracker rates, directly linked to the ECB refinancing rate, with an average spread of 1.05%. The refinancing rate was cut to zero in 2016 , meaning that those on Tracker rates have paid extraordinarily low borrowing costs for over six years, but that has changed; the refinancing rate has risen to 1.25% and will probably hit 2% by month end, so pushing the average Tracker rate to 3.05%.

Higher ECB rates have also pushed up rates on new mortgage loans across the zone, with the average in August rising to 2.21% from 1.29% at end-2021. Irish rates actually fell over the same period, to 2.64% from 2.69%, and are now below that of Germany, illustrating that local conditions can play a significant role.

There are two specific Irish factors at work. One is the scale of excess deposits in the banking system here, reflecting a longer term upward move in the household savings ratio, the impact of the various Lockdowns on spending and the low rate of house building, with a concomitant impact on mortgage lending, the main driver of Irish bank assets. In August, Irish household deposits amounted to €147bn (from €109bn three years earlier) while in Irish headquartered banks deposits exceeded loans by €83bn (which is probably the main reason the Central Bank has eased the controls on mortgage lending)

The average interest rate on most of these deposits is virtually zero (0.02%) so domestic banks here have a significant funding advantage over the main non-bank mortgage lenders. The latter have made significant inroads in the market of late (accounting for 13% of all new mortgage lending in 2021) but are more dependent on market rates , so offering Irish banks the opportunity to regain some market share.

Ultimately higher market rates will have an impact of course but the pass through from ECB rates to money market rates is not 100%. A huge factor is the amount of excess liquidity in the euro system, which currently stands at €4,500bn, in turn reflecting the impact of ECB long term loans to EA banks (TLTRO III) and QE .Short term money market rates would therefore be determined by the ECB’s deposit facility rate, which in theory should set a floor for rates, but that is not happening; both the overnight rate (0.658%) and the one week rate (0.67%) are well below the the 0.75% deposit rate.

How to reduce that excess liquidity? For the moment the ECB is reinvesting all its maturing bond holdings under QE and so could start to reduce the amount it reinvests , as per the US Fed. Yet that might clash with their desire to prevent any further widening of the spread in long term borrowing costs between Germany and Italy or Greece. The TLTRO has a three year maturity and can be repaid earlier by banks but that too has thrown up problems for the ECB, as the terms are such that banks are unlikely to do that; the average rate paid by banks for the loans will be substantially below the rate they can earn by simply depositing the money back at the ECB (Irish banks drew down €21bn, which has been a significant boost to their profits, with French and German banks the main beneficiaries).

Modifications to the TLTRO are widely expected at the upcoming meeting, but retrospectively changing the terms of a three year loan would not be a good look for the ECB. Changing the rate charged on excess reserves may also be on the table.

The pass through from ECB rates to the market may not be 100% but its still pretty high, so further monetary tightening from Frankfurt will have an impact on retail rates. Market expectations as to the peak in rates this cycle are volatile, shifting in response to the latest inflation release (still surprising to the upside) and indicators on the real economy(pointing to a probable recession) . Longer term fixed mortgage rates will be influenced by the 5-year swap rate in the market, and although that has fallen back to 3% from 3.25% earlier this month it was below 1.5% in August. Shorter term,one-month rates are priced to rise to 3% next year. Remember that reflects expectations about the ECB deposit rate and implies a refinancing rate of 3.5% and therefore a Tracker rate of 4.55%. These market expectations may not be fulfilled of course but we probably need some short term downside surprise in the inflation figures to placate ECB hawks and not just weak economic data.