Author: Daniel1

ECB opens door to rate increases.

Today’s ECB press conference (3 Feb 2022) marked a very significant change in ECB rhetoric, and it now looks far more likely that interest rates are on the way up; the market is currently priced for short term rates to be 0.3% higher by year-end and to turn positive by the spring of 2023.

That may or may not materialise but it is clear that the recent upside surprises to EA inflation has shaken the ECB’s previous belief that inflation would fall steadily in the early months of 2022. That view had prompted President Lagarde to state that it was ‘highly unlikely’ that rates would rise at all this year, but when asked she refused to reiterate that line, arguing now that ‘the situation had changed’ and that the ECB was data dependent. Lagarde also noted a few times that the unemployment rate in the EA had fallen to a historic low of 7%, thus raising the risk of ‘second round’ effects i.e. higher wages feeding into higher costs and prices.

Inflation is now deemed subject to ‘upside risks’ and given that and the overall hawkish tone it was odd to see that the monetary policy statement still included the line ‘the Governing Council expects the key ECB interest rates to remain at their present or lower levels‘ (my italics), presumably an oversight.

The March meeting now assumes greater importance, as that will include updated Staff forecasts. The inflation projection for this year will almost certainly be revised much higher(it was 3.2% in the last forecast) but the crucial factor will be the figure for 2024, which was 1.8% and hence below target but could now move up to 2% or above.

The timing of any rate increase is complicated somewhat by the present ECB commitment to end QE before raising rates. The PEPP ends next month but as it stands there is no end-date fixed for net asset purchases, which from October are set at €20bn a month. So to raise rates this year the Governing council would first have to terminate net purchases.

What does this mean for Irish mortgage rates?. Any initial moves by the ECB would be through the deposit rate, which would affect market rates and hence new variable mortgage rates and new fixed rates. The refinancing rate, which affects Tracker mortgages would be unchanged initially but would probably rise as well as we move into 2023. This is not set in stone and weaker economic growth or a spike out in government borrowing costs might change things, but as its stands it appears the ECB is likely to tighten monetary policy sooner rather than later.

Modified Domestic Demand is not a measure of Irish Economic activity

The impact of multinationals on Irish GDP has in recent years prompted the CSO to publish other measures which are deemed to better capture ‘real’ economic activity and income in Ireland. Although not recognised internationally, these concepts are now often used by the Department of Finance, the Central Bank and some private sector forecasters in their projections.

One such measure is Modified Domestic Demand (MDD) but it is not a useful or indeed meaningful concept in terms of the output and income of the Irish economy.. Lets start with domestic demand itself, which is simply the total spending on goods and services by consumers and the government plus capital formation. The latter captures spending on construction, investment by firms on machinery and equipment, plus what is termed Intangibles, defined as spending on R&D and the creation of Intellectual property. This spending used to be seen as a cost but under revised National Accounts definitions is now included in the GDP figure as a source of capital creation.

To give some context, taking figures for 2020, personal consumption amounted to €100bn, government consumption was €40bn and capital formation €148bn giving a total of €288bn. The value of stocks produced but not sold is also added (€5bn), so MDD amounted to €293bn in that year. Note though that the stock component is small but is a production rather than a spending figure, unlike the other three.

Yet some of that domestic spending went on imports (i.e. goods and services produced elsewhere) which is precisely why total imports are deducted from the GDP figures to avoid inflating the amount of goods and services produced here. To say , therefore, that domestic demand will rise by 10% tells us nothing about where that demand is met from- will there be a huge boost to Irish firms or will that demand be satisfied by firms abroad. Similarly no account is taken of exports. It is one thing to argue that some multinational exports help to overstate Irish income and output but another to ignore all exports from whatever source, be it from indigenous firms or multinationals; €150bn of exports in goods alone were shipped out of this country in the first eleven months of last year.

Then comes the modified bit. The capital formation figures, as noted , include spending on Intangibles, which in Ireland are dominated by multinationals, extremely volatile even on an annual basis and exceptionally large. They boost capital investment but in effect have little impact on total GDP because most are service imports ( and hence take a negative sign in the GDP sum). While other imports are ignored the CSO modify the domestic demand figure by deducting R&D and Intellectual property imports, amounting to €100bn in 2020. One final deduction is made, which is the value of aircraft relating to leasing , although much smaller in impact, at €9bn in 2020. As a result modified capital formation drops to only €38bn (from €148bn) so MDD in total is reduced to €183bn from the original €293bn. GDP in that year was €373bn.

One argument put forward in defense of MDD is that it is highly correlated with employment, which is true, but the correlation between employment and GDP over the past decade is also very high, at 0.97. It is simply not a measure of output or income in Ireland, or even the output of the domestic economy. One final point: forecasting Irish GDP is difficult enough, but good luck in projecting spending on intangibles, which is the main modification in the MDD concept.