Wednesday 18 September 2019

David Chance: 'Why an ECB rate cut is the last thing that Ireland needs'

The European Central Bank headquarters on the River Main in Frankfurt, Germany. Photo: Bloomberg
The European Central Bank headquarters on the River Main in Frankfurt, Germany. Photo: Bloomberg

David Chance

Dismal German industrial data released yesterday all but set the seal on a rate cut by the European Central Bank (ECB) come September, and that is not good news for Ireland, where the economy is close to overheating.

The economy here looks set for yet another stellar year, despite the risks of Brexit, with our Central Bank moving to increase its growth forecast for this year to 4.9pc, after more than 8pc growth in 2018.

The Central Bank and its former head, Philip Lane, have spent years warning that the Government needed to rein in spending and build budget buffers, saying overheating was a threat to the economy.

In his pre-Budget submission in October last year, Dr Lane warned that "if fiscal buffers are not built up, there is a risk of repeating the historical patterns by which economic downturns have been amplified by pro-cyclical fiscal austerity".

Now chief economist at the ECB, Dr Lane is preparing to unleash another round of rate cuts on the eurozone, as well as a return to the bond purchase programmes that helped prevent the bloc from sliding into stagnation.

But the policies that worked when the ECB launched quantitative easing in 2015 may no longer work today, and might in fact exacerbate fears of a perma-recession.

Then, Greece was in default and market risk in the likes of Italy was threatening to rip the eurozone apart. Cue the bond purchases, and 10-year yields fell by 30-50 basis points in core countries, and by twice that in Italy and Spain. With German 10-year bond yields hitting an all-time low of negative 0.56pc yesterday, the question is what further rate cuts and more quantitative easing can achieve.

Action by the ECB will also let governments in Germany and the Netherlands off the hook.

Both are effectively using negative borrowing costs to pay down their own debt, instead of investing and stimulating their economies to boost demand, and to help the eurozone stave off recession.

The evidence so far for low rates working in Ireland is far from conclusive. In response to near-zero rates, Irish households are squirrelling away more money in low-yielding deposits at banks, and that is not a mark of confidence. Our Central Bank's data shows that household deposits grew at their most rapid rate in the first quarter of this year since the fourth quarter of 2008, when the global financial crisis hit. Deposits currently stand at close to €100bn.

The ECB argues, in part, that it needs to ease policy to stave off the threat of deflation.

While it is true that the headline rate of inflation here is extremely low, at just 1.1pc, that figure is highly distorted, in part thanks to the plunge in the value of the pound due to Brexit, which reduces the cost of goods imported from the UK.

A better read of the 'health' of inflation here comes from the services sector, and in the same period, that reading was up a robust 2.6pc.

What cuts in ECB rates will likely achieve is a rush for yield. And given there is none in government bond markets, more money will flow into high-risk assets like corporate debt, and into areas such as Ireland's real estate market, which is awash with money thanks to the trillions of euro now parked in investment funds here.

The hunt for yield risks destabilising financial markets and may sow the seeds of the next recession. Rate cuts will also place an unwanted burden on fiscal policy here.

Minister for Finance Paschal Donohoe has rebuilt public finances since the crash, and his projections that the State would record a second successive budget surplus this year were endorsed by ratings agency Moody's earlier this week.

The Minister already has a tricky task managing fiscal policy at a time when a hard Brexit is looming.

Asking him to triangulate the potentially distorting impact of coming ECB rate cuts as well will be a huge challenge, and it would be a tragedy if economic overheating here were stoked by impending rate increases, prompting calls for spending to be cut to lean against the impact of a monetary boost.

Economic history is littered with examples of what happens when monetary policy and fiscal policy work in opposite directions, and this rarely ends well.

Germany needs a fiscal boost, not a monetary one, and Ireland will be ill-served by the ECB letting Berlin off the hook.

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