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.

Irish bond yields supported by low and falling debt ratio and Budget surplus.

Government bond yields in Europe and the US have risen substantially in response to higher inflation, rising short term interest rates and the prospect of more supply as States boost sending to cushion the economic impact of soaring energy prices. The German 10yr benchmark bond , the nearest we have in the euro area to a risk free or ‘safe’ asset, is currently trading at 2.15% from 0.7% just two months ago, with the rise in yields in other member states generally more pronounced.

Investors appear to like Irish bonds in this environment, as the 10yr benchmark here is currently trading at 2.68%, and as such below France and Finland, despite both having a higher credit rating than Ireland (AA- on S&P) .

One factor is Ireland’s low and falling debt ratio. The recent Budget projected Irish Government debt to fall by €10bn this year to €225bn, which alongside a projected GDP figure of €500bn gives a debt ratio of 45% from 55% in 2021.The net debt estimate for 2022 is lower still, at €190bn (largely reflecting cash balances at the NTMA from previous over-funding) which gives a ratio of only 38%. Gross and net debt debt is projected to be broadly unchanged in 2023 but given the forecast growth in the denominator the respective ratios fall to 41% and 35%.

Ireland is also probably alone in the euro area in projecting a budget surplus this year and next. In 2023 the Exchequer surplus is forecast at €1.7bn, which alongside scheduled debt repayment of €9bn implies the need for very limited bond issuance. The euro system owned €73bn of the €156bn bonds at issue at end- September, so the ‘free float’ that can be sold is low.

This relatively low yield on Irish debt also comes after the 2023 Budget with its headlines of an €11bn tax and spending ‘package’, although the presentation can cloud what the Budget actually delivered. Fortunately the Government produces a ‘White Paper’ ahead of Budget day, setting out fiscal estimates for the current and coming year pre-Budget, so allowing a simple comparison with the post-Budget projections.

For 2022 the pre-Budget estimate was for an end-year Exchequer surplus of €5.9bn, against a post-Budget figure of just €345m, a big difference, reflecting the ‘cost of living’ supports of €4.1bn and a €2bn injection into the National Reserve Fund ( the latter is a cash flow out of the Exchequer and so reduces the potential Exchequer surplus but has no effect on the General Government balance). The package also included €0.6bn from money ‘saved’ from the original 2022 budget estimates. So over 40% of the announced measures in Budget 2023 were actually one-off measures for this year.

Turning to next year, the White Paper had forecast a pre-Budget Exchequer surplus of just under €10bn, which post-Budget had fallen to €1.7bn, again a big change due to decisions taken on the day by the Minister for Finance. One was to allocate €4bn to the Reserve Fund, then to increase spending and to cut taxes, with tax revenue €1bn lower largely due to income tax changes. Note though that net current spending is unchanged relative to 2022, as the latter included a €10bn contingency, largely for Covid support, and this falls to €4.4bn in 2023, including a €2bn Ukrainian contingency , so broadly offsetting the increase in ‘core’ spending. Tax revenue is forecast to rise by €5.4bn or 6.6% so the current budget surplus rises to a projected €18bn from €13bn in 2022.

Its also worth noting that the Government seems to share the market’s belief that Ireland’s fiscal position is not a big issue, given the decision to inject €6bn into the Reserve Fund , as debt would have been €6bn lower absent that decision, What constitutes a ‘rainy day’, which would trigger the use of the Fund, remains to be seen.

Irish economy still growing at double digit pace and on course for €500bn.

The Irish economy grew by 13.6% in real terms last year and the annual growth rate remains remarkably strong, at 11.1% in the second quarter from 10.8% in q1. Growth may soften over the second half of the year, notably from weaker consumer spending, but absent a fall in exports a 10% figure looks plausible.

On a quarterly basis GDP grew by 1.8% in q2, with the expansion more balanced than often seen in the Irish data, where exports dominate. Consumer spending had fallen for two consecutive quarters but rebounded in q2, rising by 1.8%. This may seem at odds with the very weak retail sales seen of late but the latter also rose in q2, albeit solely due to a surge in spending in April, with sharp declines to July. The implication is that consumer spending may fall again in q3.

Government spending also rose in q2 , by 2.7% and there was also a strong rebound in capital formation, rising by 17.9%. Building and construction spending rose by 4.8% in the quarter,while investment in machinery and equipment increased by 26% , with spending on Intangibles also positive, at 22%.

Strong domestic demand, particularly from investment, would normally be reflected in imports, and growth there was 5.5%, which outstripped export growth of 3.3%. GNP, which adjusts for net profit and interest outflows , also expanded, by 2.1%.

The annual GDP figures also reflect the scale of price inflation seen this year, notably in external trade, construction and consumer spending. Consequently GDP in nominal terms rose by an annual 17.7% in q2 following a 15.7% rise in q1. Absent a contraction in the second half of the year the implication is that the combination of very strong real growth plus the impact of inflation could result in Irish nominal GDP rising by 17% , so reaching €500bn for the full year.

Irish Housing Market Update

House prices in the US, the Euro Area(EA) and the UK have seen strong and persistent growth in recent years, driven by similar factors- low supply relative to past experience, very low interest rates by historical standards and significant monetary and fiscal stimuli in response to the Pandemic. Monetary policy has now changed and signs of a slowdown in the housing cycle have appeared although as yet this has precipitated a softening in price momentum rather than any significant price falls.

The latest Irish residential price index illustrates the point; prices rose by 2.3% nationally in the three months to June, but at a slower pace than seen in the same period a year earlier so the annual change in prices slowed, albeit not dramatically, to 14.1% from 15.0% in March.In Dublin price inflation slowed to 11.7% from 12.5%, while the figure excluding the capital was 16% from 17.1%.

June also saw the index climb back up to the previous cycle peak recorded in April 2007, although house prices are now 2.4% above the previous high after reaching that level in March, while apartment prices are still 14% below their 2007 peak. Prices remain supported by limited supply and a big fall in the real interest rate (nominal mortgage rates on new loans have not risen year to date while the CPI has spiked) although real incomes are falling and hence acting as a negative for house prices. Prices did rise strongly in the latter half of 2021 and that base effect alongside slower monthly increases for the rest of this year may result in and end-year house price appreciation figure of around 8%.

On supply , annual completions have been around 21,000 over the past three years and the 2022 total may well pick up to around 26,000 given that the figure for the first half of the year was over 13,000, although some analysts have paired back their initial forecasts in response to the surge in construction costs. This may dampen housebuilding in the coming year rather than impact supply already under construction however.

Transactions have also picked up this year which is consistent with an increase in completions, amounting to 32,615 in the first six months of the year, against 31,405 in the same period of 2021. For the full year we expect 72,000 from 68,000 last year and 67,000 in 2019.

The number of new mortgages relative to market transactions has risen in recent years to 59% from a low of 50% in 2015 and looks on course for a similar share this year. New lending for house purchase rose to €4.4bn in the first half of 2022, from €3.5bn in the same period last year, reflecting a strong rise (10%) in the average new mortgage, to €267,000 , and a similar percentage increase in the number of new loans for house purchase, taking that total to over 16,000. For the full year we expect the latter to rise to 34,000 with a value of €9.9bn. The headline new mortgage lending figures include tops ups and switching, and the latter has risen sharply over the past few years and we expect a figure of €2.5bn in that category this year, up from €1.6bn in 2021. Overall mortgage lending is forecast at €12.6bn from €10.5bn in 2021.

As noted above new Irish mortgage rates in June were unchanged from the end-2021 figure, at 2.68%, in contrast to experience elsewhere in the EA, where rates rose fro 1.31% to 1.94%. This reflects the high level of deposits relative to loans in Ireland, allowing the main lenders to absorb the rise seen in longer term market rates. That is unlikely to continue particularly as July saw the first of what is likely to be a series of ECB rate increases. The share of fixed rates in new lending has been well over 80% in recent years and so the share of variable rates in terms of outstanding loans has now fallen below 50% so lessening the impact of ECB actions.

Finally, rents are also rising very strongly, with the CPI in July recording a 12.9% annual increase in rents actually paid by tenants. In our view employment is the key driver for rents, alongside the housing stock, and the former will probably rise by over 100,000 this year or 5%. The housing stock per head is still falling, exacerbated by a dwindling supply of properties for rent, so it is not surprising to see double digit rental increases. Employment growth may slow somewhat in 2023 as workers are scarce and on that basis we may see some easing in rent inflation, back to single digits, but absent an employment shock rents are unlikely to slow appreciably.

Irish consumers cut spending

The US economy contracted for a second successive quarter in q2, so fulfilling one of the most common definitions of recession, although consumer spending there is still growing and the economy is around full employment. Growth in the euro zone, in contrast, has surprised to the upside in the first half of the year, contrary to expectations , in part due to a big rebound in tourism across France, Italy and Spain, although markets are still projecting a period of very weak or falling GDP which it is assumed will limit the degree to which the ECB can raise interest rates.

The future path of Irish GDP will largely depend on how the external sector performs and the composition of exports makes it less likely that a big decline there will materialise judged on the evidence from the Pandemic period. The labour market here also appears robust, although it is clear that households have retrenched in response to the surge in consumer prices since last autumn.

Indeed, we have seen two consecutive quarters in which real consumer spending fell; the decline in the final quarter of last year was modest, at 0.6%, but that was followed by a sharper fall in the first quarter of 2022, at 1.3%. Retail sales , a more timely indicator of household spending, did recover in the second quarter, rising by 2.2% in volume terms, but that was due to a big increase in April, as sales have actually fallen in nine of the past twelve months. Excluding the motor trade, retail sales also picked up in q2, albeit by only 0.5%, and again reflecting a strong April as sales fell in May and June by a cumulative 4%.

The annual change in the monthly retail sales data is volatile given the distortions due to Lockdowns last year but the fall in June was notably large, at 6.6%, with only two sectors recording positive growth- Bars and Chemists- so the squeeze on real household incomes is clearly biting. CPI inflation was probably unchanged in July at 9.1%, a welcome respite if true following five consecutive months of acceleration, and the ongoing fall in fuel prices offers some hope that we may be at or near the inflation peak. The scale of the weakness in retail sales may also prompt shops to offer more sales, so putting additional downward pressure on the monthly CPI but the big upside risk remains the broader energy picture, with European gas prices still rising and hence feeding through into higher home heating costs.Ireland may avoid a recession in terms of GDP but household spending and the High Street have not escaped.

ECB shreds Forward Guidance playbook and unveils OMT lite

The Covid pandemic prompted a massive fiscal response across the developed world and major central banks unveiled further monetary stimulus, which in the ECB’s case took the form of additional bond purchases (the PEPP) and the provision of long term funding to the banking system on attractive terms (TLTRO III). Central banks as a group were also of the view that the pick up in inflation through 2021 was ‘transitory’ and therefore did not require monetary tightening.

Inflation at the time of the ECB meeting last December was 4.9% and the Bank forecast an average inflation figure of 3.2% for 2022, with a fall back below the 2% target the following year. It did signal that the PEPP would end in March but that its maturing holdings would be reinvested till end-2024 while no end-date was set for its Asset Purchase programme. Reinvestments from the latter would continue for ‘an extended period’ after the first rate increase.

The invasion of Ukraine added further upward pressure on elevated energy prices, notably natural gas, and inflation in Europe and elsewhere consistently surprised to the upside, prompting the ECB to respond in June by signalling rate increases to come, albeit still buying bonds till the end of that month.A quarter point increase in ECB rates was pre-announced for the 21 July meeting, with another rate increase to follow in September, although the latter could be higher depending on the inflation performance. The Governing Council also anticipated ‘that a gradual but sustained path of further increases in interest rates will be appropriate’. The accompanying forecasts projected a gradual fall in inflation to 3.5% next year and 2.1% in 2024, with the decline due to  ‘moderating energy costs, the easing of supply disruptions related to the pandemic and the normalisation of monetary policy’.

Longer term market rates have moved higher in anticipation of monetary tightening , although expectations have been volatile , fuelled by fears of a global recession; 5-year euro swap rates spiked to 2.20% a month ago, from zero in early February, but have fallen back since, declining to 1.5% before a recent rise to 1.75%. Government bond yields have also risen but not in a uniform manner, with Italy in particularly seeing a significant widening in spreads to Germany. The ECB views this as ‘fragmentation’ and promised to announce a policy tool to counter it on top of using PEPP reinvestments in a ‘flexible manner’, meaning using the proceed of an Irish bond maturity, for example, to buy more Italian debt.

Today’s ECB meeting was surprising on a number of fronts. First, President Lagarde announce a 50bp rise in ECB rates instead of the signalled quarter point, citing the recent inflation data and the weakness of the euro. Second, forward guidance on rates has been abandoned, with a ‘meeting-by-meeting approach to interest rate decisions’, meaning that the September rate decision is now open. ‘Further normalisation will be appropriate’ but she refused to be drawn on what a ‘normal rate’ might look like. Gone also was the previous reference to maintaining ‘ optionality… gradualism and flexibility in the conduct of monetary policy’ although one could argue they were mutually exclusive anyway.

The new anti-fragmentation tool duly appeared with yet another acronym – TPI or Transmission Protection Instrument. This has no set limits and can buy public sector debt from 1-10 year maturities ‘to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area’. Eligibility is conditional though on a given country pursuing ‘ sound and sustainable fiscal and macroeconomic policies’ including complying with the European Commission’s country specific recommendations on fiscal policy and recovery and resilience plans for the Recovery and Resilience Facility.

So in effect the ECB is becoming an enforcer of the EU’s fiscal rules, as was indeed envisaged a decade ago with the creation of Outright Monetary Transactions (OMT).. That required strict fiscal surveillance under an ESM adjustment programme and was never actually triggered so this could be considered OMT lite, with the ECB again as fiscal enforcer but with longer maturity purchases ( OMT was out to 3 years).

One area left vague in the TPI announcement was how the ECB will ‘sterilise’ any bond buying to avoid raising its existing bond holdings or adding to the already huge excess liquidity in the system. That detail will be very significant for the market and as yet there has not been a significant reaction in terms of the euro or interest rate expectations.

Irish Budget change does not make sense

The Irish Government has announced that the 2023 Budget will now be delivered on 27th September, two weeks earlier than planned. This makes little sense and far from bringing it forward there is a strong argument for pushing it out to later in the year, given the degree of uncertainty about energy prices and the risks of a global recession.

In fact ,delivering the following year’s budget in early October , let alone September, risks major forecasting errors, as illustrated in the 2022 Budget. The Government projected tax receipts in 2022 of €70.2bn, or 6.2% above the expected end-2021 outturn of €66.1bn. In the event the latter emerged at €68.4bn, so implying tax growth of only 2.7% in 2022. As the year unfolded a combination of higher real growth than predicted, much stronger employment gains and the spike in inflation rendered redundant the original Budget projections. In April the Government revised the tax target up by €5.5bn, to €75.8bn, and slashed the projected Exchequer deficit from €7.7bn to €1.1bn.

That forecast now looks wrong given the Exchequer figures to end-June and the Summer Economic Statement notes that the budget will probably be in surplus this year and next, albeit without providing any detail (if so Ireland will probably be alone in the euro area in not running a fiscal deficit). Tax receipts are 25% ahead of the same period last year while non-tax revenue is also much stronger than budgeted, including a transfer from the Central Bank of over €1bn and €650m from the sale of bank shares in AIB and BOI. As a result the Exchequer is running a surplus year to date of €4.2bn, and the NTMA’s cash balances (from overfunding) have risen to €35bn.

The Government has already taken some measures to partially offset the impact on households of the surge in energy prices, including a temporary cut in excise duty on fuel, and now intends to spend €400m more than originally budgeted in 2022. The Minister for Finance cannot put tax receipts from this year in a drawer and produce them in January so any tax or spending measures in the 2023 Budget are dependent on forecasts for tax growth next year.

The exact sums the Government plans to spend are clouded somewhat by the distinction made between ‘core’ gross voted spending, both current and capital, and total voted spending, as the latter has of late included one-off’ items largely related to Covid supports. These one-off sums are projected at €7.5bn this year , which alongside a ‘core’ total of €80.5bn gives a total gross voted spend of €88bn At end-June spending was €38.5bn, implying a spend of some €50bn in the next six months if the plans are met.

The Government had announced that it intended to limit the annual growth in ‘core’ spending in the medium term to 5%, implying a rise in 2023 of €4bn. That was predicated on inflation of around 2% which is clearly no longer plausible and the rise now planned for next year is €5.3bn, or 6.5%, taking the total to €85.8bn. Some €3bn of that has already been allocated leaving the balance to be decided on Budget day, with a tax package of €1.1bn also flagged.

What matters for the overall Budget arithmetic is total spending and there the planned rise is much lower, at €2.3bn, taking the total to €90.3bn, which explains why a Budget surplus is expected. The ‘one-off’ spending component is projected to fall to €4.4bn from €7.5bn as Covid supports dwindle, with the bulk of the total now a ‘Ukraine Humanitarian Contingency’.

The 2023 Budget is billed as a ‘cost of living’ budget, with extra sending and tax reductions to help cushion some of the impact of higher inflation, but those will come into effect next year. Moreover, as they have already been signalled there is no longer an ‘announcement effect’ in the Budget, whenever it is held. The Budget will include detailed economic forecasts and of course a prolonged period of high inflation and/or a marked global slowdown could again derail the Budget assumptions.

Can the ECB raise rates aggressively given the Fragmentation risk?

The Euro has a fundamental flaw in that member states have fiscal sovereignty but not monetary sovereignty, which is the exclusive preserve of the ECB. Unlike say the UK or the US, EA governments cannot print money in order to fund fiscal deficits if markets are unwilling to buy that debt. As we saw in 2010, that inability precipitated a full-blown existential crisis for the single currency, which was eventually resolved by a changing of the guard in Frankfurt and Draghi’s ‘whatever it takes’ pledge a decade ago..

That involved the creation of bond buying programme known as Outright Monetary Transactions (OMT) designed to buy the bonds of member states where yields were deemed too high and therefore impairing the full transmission of monetary policy-‘fragmentation’ in the ECB lexicon. Access to OMT was to be at a price though-fiscal discipline, with member state eligibility dependent on fiscal retrenchment.

In the event OMT was never used but in 2015 the ECB embarked on QE, buying the bonds of all member states in an effort to combat the risk of deflation. The ECB now holds €5,000bn in bonds ‘for monetary purposes’, about 41% of EA GDP, including €1,700bn from its PEPP programme introduced in 2020. QE is essentially an enormous Swap transaction, in that the ECB receives fixed interest rate coupons on the bonds it holds while paying a floating rate to banks on their reserves, created by the ECB. That makes the ECB vulnerable as rates rise on those reserves.

The ECB is now faced with an inflation problem, which has accelerated far faster than most expected,consistently exceeding ECB expectations. Indeed, in last week’s staff forecasts, inflation was expected to peak in May at 7.5% but a footnote to the forecast acknowledged that the May figure (released after the forecast cut-off point) had been 8.1%, with the expected average for the year now seem as above 7%.

The Bank has now indicated it will tighten policy by raising rates, starting in July and then September, but had already committed to reinvesting PEPP holdings till end-2024, with the €3,300bn QE holdings also reinvested, this time for an ‘extended period’ after rates had started to rise. So it is still injecting huge liquidity into the monetary system while raising the cost of credit.

The prospect of higher short term interest rates has pushed up longer rates, as one might expect, but not evenly across the EA. German 10 year bonds currently yield 1.60% from -0.40% six months ago, a rise of 200bp, while Italian yields are now up at 4%, having risen by 310bp over the same period. Italian debt amounts to 150% of GDP and so a prolonged period of yields that high, or even higher, alongside limp growth, will push the debt burden up in the absence of much tighter fiscal policy. The latter is difficult politically at the best of times but more so now in the face of calls for much greater support for households struggling with the explosion in energy costs. Ireland seems to be out of the firing line, in that the spread with bunds has only increased by around 25bp, with the yield at 2.30%.

  How will the ECB combat fragmentation? Initially via the PEPP it would seem, with Lagarde emphasising flexibility in reinvesting the existing holdings across jurisdictions. Further, we are told ‘ the ECB will deploy either existing adjusted instruments or new instruments that will be made available’ It’s hard to see what other instruments could mean other than bond purchases (the OMT or an expanded PEPP?) which in effect would amount to intervening when yields have breached some target level. Deciding on that target is another issue of course but would in any case mean the ECB would be trying to control both short term rates and longer term rates.

There is also the issue of legality. The ECJ deemed QE as within the ECB’s mandate but there are fresh challenges to the PEPP, which does not have issuer limits. A clear peak in inflation over the next month or so might help to calm things down but the fragmentation issue raises the question of whether the ECB can tighten aggressively if in doing so it risks triggering another full-blown euro crisis.

Domestic spending falls but exports spur double digit Irish growth in First quarter

Ireland’s economic performance in the first quarter of the year was marked by a dichotomy between domestic spending and exports; the former fell, no doubt impacted by the acceleration in inflation, while the latter grew strongly. The net impact was a double digit rise in GDP,which also implies that the consensus growth figure for the full year, currently around 4%, is too low.

The monthly data on industrial production and Irish trade had implied a strong quarterly reading in exports, although the national accounts figure also includes output manufactured offshore, largely in China, so adding a degree of uncertainty given the Lockdowns there. In the event the outsourcing component was lower than of late but not enough to prevent a 5.2% quarterly rise in the volume of exports. which boosted GDP by 7.5 percentage points. There was also an unusually large contribution from stock building of 3.8 percentage points and these two components largely explain the 10.8% surge in q1 GDP.

The consensus view this year envisages strong growth in consumer spending, in part fuelled by a big fall in the savings ratio, although we are skeptical on that issue. The upside surprise in inflation may also be having an impact though, and personal consumption actually fell in volume terms in q1, by 0.7%, following a 0.5% decline in the final quarter of last year. Government consumption also contracted in volume terms, by 0.4%, while the other component of domestic demand, capital formation, plunged by 39.5%, driven by another large fall in spending on Intangibles . This component is extremely volatile on an annual let alone quarterly basis but is broadly GDP neutral as most of it is also captured as a service import (which reduces GDP) . Consequently that component fell sharply in q1 , by 19%, with total imports falling by 12%.

The annual growth rate of GDP picked up to 11% in the first quarter, from 9.6% , and as such means that Ireland would have to record a recession in the coming quarters to leave the average for the year anywhere near the 4% consensus. GDP growth forecasts will therefore probably be revised up in the near term, although domestic demand projections are likely to be revised down, notable consumer spending.