Full employment and spending pressures impact medium term fiscal outlook

The Irish Government has just published its annual Stability Programme update(SPU), as mandated by the EU, setting out fiscal projections out to 2027, although this will be the last update in this form as revised fiscal rules will require the publication of a five-year fiscal Structural Plan (more on that below)

For context, Ireland has been running very large current Budget surpluses , supported by substantial inflows in Corporation tax. In 2023 , for example, current revenue amounted to €90bn, against current spending of €73bn and if both are assumed to rise at broadly the same pace the absolute surplus grows over time , and was projected to exceed €24bn in 2026 . Of course the Government has used this excess revenue to fund capital spending, but this still left the Exchequer as planning to run overall cash surpluses into the future, raising the question of whether it would be better for Ireland to run down debt at a rapid clip or to use the surpluses to fund future spending.

The Government chose the latter option and set up two funds; the Future Ireland Fund(FIF) will be managed as an investment fund out to 2035, receiving an Exchequer transfer of 0.8% of GDP each year in order to help cope with fiscal pressures arising from an ageing population, while the Infrastructure , Climate and Nature Fund (ICNF)will be a shorter term counter cyclical vehicle for infrastructure spending out to 2030, receiving €2bn annually from current receipts. This still leaves the Exchequer running projected surpluses, and hence nominal debt falling,and the State running much larger General Government surpluses as these transfers are included in the latter, along with surpluses in the Social Insurance Fund.

What has changed in the SPU? .For the 2024 outlook very little, which is surprising as forecast GDP growth this year has been revised down and tax receipts to date are running behind profile. However, the Department of Finance expects this to largely correct, so tax receipts are projected to emerge only modestly behind target, with higher voted current spending offset by reduced spending elsewhere, including lower than forecast EU contributions and a lower contribution to the FIF (because GDP fell last year). The net result is that the projected Exchequer surplus is now seen some €0.7bn higher at €2.5bn, with the General Budget Surplus marginally higher at €8.6bn.

A comfortable fiscal position therefore is expected ahead of the 2025 Budget and the General Election but in contrast there are significant changes to the outlook further out. The economy is deemed to be at fill employment and so employment growth and therefore GDP growth is constrained by labour supply, although net migration is assumed to rise by 35,000 a year. Inflation has also been revised down so GDP in 2026 is now forecast at €600bn or €50bn below the previous projection. As a result tax receipts at that point are lower than was envisaged but the big change is on the spending side, with gross voted current spending in 2026 €5bn higher than forecast last October.’Core expenditure’ is still projected to rise by 5% per annum , albeit against a higher 2023 base , but the contingency reserve has been rolled on to these years, including ‘ Covid-related spending primarily in Health, costs relating to accommodating and supporting beneficiaries of temporary protection from Ukraine and expenditure related to EU funds’.

The upshot is that the Exchequer is now forecast to be running a deficit in 2026 and 2o27 , some €3bn in total, and the General Budget Surplus (which is nstill assumed to include the transfers to the two funds) is smaller , at €8.7bn instead of €14.6bn. The Exchequer deficit therefore means Ireland will actually be borrowing, albeit small sums, at least in part to fund the FIF and ICNF. Nominal debt will therefore rise modestly but given the low interest rate on the debt and GDP growth the debt ratio continues to fall, to 36.7% of GDP by 2026,although the October forecast was 33%.

As noted above this will also be the final SPU. The EU’s latest revisions to its fiscal rules put greater emphasis on each State setting out a five-year plan including spending commitments consistent with a falling debt ratio. Ireland’s debt ratio is already well below the 60% reference value set out in the Growth and Stability pact but will still be required to publish a five-year strategy, set to commence in the Autumn.

Dublin leading acceleration in house price inflation

Residential property prices in Ireland have picked up markedly over the past few months, supported by rising real incomes (given the fall in CPI inflation) and the expectation that ECB rates will fall this year, with the June policy meeting likely to see the first cut . More mortgage borrowers are certainly of that view, with 26% opting for floating rates in January, a significant change from the 5% or so seen over recent years.

The CSO’s house price index for January confirmed the more buoyant trend, with residential price inflation nationally accelerating to 5.4% from 4.1% in December. The national index has been supported by price gains excluding Dublin but that appears to be changing; Dublin prices were weak in 2023 and last summer were down an annual 1.8% but have picked up strongly of late, rising by 3.5% in the three months to January. Houses in Dublin City have seen the strongest recovery, up by 3.9% in three months, taking the annual increase to the past year to 6.2% from 2.8% in December. In county Dublin the annual change also accelerated strongly to 4.6% from 2.5%. The annual change in Dublin is flattered by base effects (as prices fell in January last year) and this is likely to remain a feature up to mid-year, with even modest monthly gains leading to a 9-10% annual figure.

That base effect will be less of a feature in the rest of the country, albeit still present, and prices have also picked up on a monthly basis, by 2.7% in the past three months. That has boosted annual price inflation excluding the capital to 6.2% from 5.3%. Annual property price inflation is strongest in the Mid-West (Clare, Tipp and Limerick) at 9.5%, followed by 9.3% in the Midlands ( Laois, Offaly, Longford and Westmeath)

Irish Tracker holders to get unexpected bonus from ECB

Tracker rates in Ireland became the norm in the early noughties,linked to the ECB’s refinancing rate (refi rate) with a spread, which averaged around 1.1% . Consequently the ECB’s current refi rate of 4.5% translates to a Tracker rate of 5.6%, although for years borrowers paid only 1.1% given the refi rate was at or near zero from 2014 to July 2022.

The refi rate is the rate banks pay to borrow from the ECB and used to be the main instrument used by the Bank to control short term interest rates in the euro area. However, that changed when the ECB started to flood the market with excess liquidity in an attempt to get inflation back up to the 2% target and so the Deposit Facility rate (the rate the ECB pays banks for deposits) became the effective operational rate . The spread between the refi and deposit rate has varied over time but since 2019 has been set at 50bp, with the current deposit rate at 4%.

That is set to change from mid-September according to an announcement setting out the ECB’s proposed new framework for guiding euro rates .The issue arises because excess liquidity is falling and the ECB is looking ahead and to the kind of operational framework they will adopt when liquidity is tighter. They have decided that the Deposit rate will still be the key driver of rates but as liquidity ebbs money market rates may well start to rise above that floor.Banks will be able to borrow all they need at the refi rate, so that will put a ceiling on rates but the spread between the two will fall to 15bp from the current 50bp in order to maintain a tighter corridor.So even if the deposit rate in September was still 4% the refi rate falls to 4.15% and Tracker rates decline by 35bp. Of course the market is actually priced for cuts to the Deposit rate by then, to say 3.5%, which if it materialises would mean tracker rates will fall by 85bp to 4.75%. The market is currently priced for a cycle low in the deposit rate of 2.25%, which implies a Tracker rate of 3.5%..

Irish economy contracts by 3.2% in 2023.

The Irish economy, as measured by real GDP, contracted for four consecutive quarters last year, with the annual figure falling by 3.2% . Nominal GDP also declined, to €505bn from €506bn in 2022. The pace of decline accelerated through the second half of the year and real GDP fell by 3.4% in the final quarter, substantially worse than the initial -0.7% flash estimate. That left the annual change in the final quarter at -8.7%, which gives a very weak carry over into 2024, and the economy may well struggle to record positive growth even with a recovery in external trade.

Exports have been the engine of Irish growth for a long time now but 2023 saw a sharp reversal of the seemingly inexorable rise, with a 4.8% fall in volume terms following double digit annual gains over the previous four years. Service exports held up well, rising by over 8%, but there was an extraordinary collapse on the merchandise side, by €45bn or 13%. Goods shipped from Ireland fell by €10bn, reflecting weaker Pharma and organic chemicals, but goods outsourced to production abroad, largely in China, fell by €34bn, probably down to a specific phone manufacturer.Exports in total ended the year down 9.5% so a strong recovery would be required to give positive export growth for 2024.

Imports had also weakened through the year but rebounded sharply in q4 on the back of a surge in service imports related to intellectual property. That resulted in a modestly positive import growth for the year as a whole. The IP service import is also captured and offset by Intangibles in capital formation (therefore largely GDP neutral), so that component also rose modestly in 2023, despite a 1% fall in building and construction.

Consumer spending rose by over 10% last year, but prices increased by 7% so spending in real terms grew by 3.1%, with a notable switch by consumers to cars and services amid soft retail sales. Despite this growth, modified domestic demand rose by only 0.5%, dampened by the fall in construction and a decline in investment in machinery and equipment.

These GDP figures and indeed the modified domestic demand outturn sit uneasily with other data such as tax receipts and employment growth (up by 90,000 last year or 3.4%) and in this case GNP might be a better reflection of underlying economic activity: that adjusts GDP for profit and interest flows, and the net outflow was lower last year so GNP actually rose strongly, by 4.4%.

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.