Speech to Irish Home Builders Association

Rate cycle at or near peak

The global economy is experiencing an unprecedented boom, and 2007 is likely to see growth of around 5% for the fourth consecutive year. This has supported equity markets and commodity prices, while also prompting Central Banks to raise interest rates. However, we may now be at the peak of the rate cycle in some countries and near the peak in others. Interest rates in the US, for example, are likely to fall before year end, and 5.5% may turn out at be the peak for UK rates. Closer to home, the ECB may raise rates to 4% but this too may prove to be a cyclical peak - the euro economy is losing some momentum, bank lending to households is slowing, and inflation is well-behaved. Moreover, Central Banks now realise that at some point they have to pause to observe the full lagged effects of tighter monetary policy.

Spate of bearish forecasts on Irish economy

In Ireland there has been a spate of forecasts projecting a slowdown in growth, but in truth most of the current macro-indicators, (including retail sales, industrial production, foreign travel and unemployment) do not suggest any softening in the pace of growth. Consequently, I still expect 6% growth in 2007, easing to 5% in 2008. Furthermore, it is not clear from some of these more bearish forecasts whether the authors envisage a cyclical slowdown or a structural shift in Irish growth. The former would be relatively short lived as in time lower interest rates would eventually prompt a cyclical recovery, as in the 2001 - 2003 period. A move to a lower potential growth rate would be more serious but it is not obvious why the potential growth of the Irish economy should fall from 5.5% - 6% to 3.5% - 4% in eighteen months as it would require a sharp fall in productivity or a substantial fall in labour force growth. Some even argue that the Irish potential growth rate is not currently in this 5.5% - 6% range, but if lower, unemployment would have surely fallen, when in fact it has been very stable over the last few years.

Erroneous views on Irish economy

Indeed, there are a number of economic viewpoints about the Irish economy which are often voiced but have little in the way of support from the facts. One often hears that growth is unbalanced but a glance at the data from 2001 to 2006 shows average GDP growth of 5.3%, with all components growing in a 4.5% - 5.5% range. Others complain that too many resources are being devoted to consumption but consumer spending in Ireland amounts to 46% of GDP which is not only below the eurozone norm (55%) but has fallen steadily for the past forty years. Household savings in Ireland is also relatively high (at around 10% of household disposable income), which is similar to Germany and substantially above the UK (5%) and the US (zero). This also means that many people benefit from a rising rate environment but this view is also rarely heard.

Housing market has slowed, with stamp duty uncertainty impacting

There is one area which has clearly slowed, nonetheless, and that is housing. Mortgage lending growth peaked at 28% in the spring of 2006 but had slowed to 22% in March 2007. Annual house price inflation has also decelerated, to 7.4% on the latest Permanent tsb index, which is below the pace of growth in private sector rents. This is a very unusual situation and suggests that the demand for housing has not fallen but that the decision to rent or buy is now biased to the former. One factor at work is expectations about price which has shifted of late - if everyone expects house prices to be stable or even fall there is an incentive to wait before buying. The uncertainty about stamp duty also no doubt played a part. Certainly, figures for mortgage lending support this view: Gross mortgage lending in Q1 amounted to €7.8bn, which is 7.5% down from the same period of 2006. Re-mortgaging was up almost 6%, however, while first-time buyers were down 5.7% against an 18% fall in movers. This highlights the key point that stamp duty is a secondary market issue - few first-time buyers qualify to pay it, which is why it is relatively cheap to abolish it. For example, in Ireland, it could cost 12% to move to a bigger house (9% stamp duty plus other costs) which explains why so many opt to extend their existing property. The result is that less than 30% of gross mortgage lending in Ireland goes to borrowers moving house, and a lower level of duty could well boost secondary market turnover and hence tax yield.

Interest rates more fundamental issue

The uncertainty over stamp duty will probably be resolved in 2007, either after the election or in the December Budget, depending on the composition of the new Government. A more fundamental issue remains however - the interest rate cycle. I have argued for some time that Irish house prices will show only limited growth this year and next in the face of deteriorating affordability, in turn a function of higher interest rates and a rise in the average loan size. On that basis, the market is unlikely to show a significant upturn in prices until either income has outpaced price growth for a number of years or it is clear that the rate cycle has peaked.

House prices likely to be flat or show only modest growth

The most likely outturn for the market is therefore a period of flat or only modest price growth (say 3% per year), until affordability is rebuilt. The risk of a sustained and substantial decline in prices exists but is not high, largely because the labour market remains tight, and unemployment low. One should also note that large falls in house prices are rare - prices did not fall 50% in the Netherlands, or by 35% in the UK as has been stated in a recent RTE programme. These figures refer to house prices relative to CPI inflation. For example, house prices fell by around 10% over an 8-year period in the Netherlands from 1978, with CPI inflation rising by 40% over the same period. Actual house prices are sticky downward and transactions usually respond more than prices.

Plenty of examples of soft-landings, including Ireland in 2001

This argues for a soft landing for the housing market, and it is worth remembering that we have already had one in Ireland, in 2001 - 2002. Prices fell for five consecutive months from August 2001, by a cumulative 4%, and new mortgage lending fell by an annual 6% in the final quarter of that year, resulting in a decline in the growth of the mortgage stock to 17.8% for the year, from 24.5% in 2000. Moreover, the past five years has seen examples of soft landings after housing booms in the UK, Australia and the US.

Irish housing supply very responsive to price

Housing supply in Ireland has proven very responsive to house prices in the past decade, rising at an extraordinary pace since 2003 - some 700,000 units have been built, with almost 40% of the housing stock now less than 14 years old. Moreover, none of this was outlined in some grand master plan - it reflects the private sector shifting resources in response to the unprecedented demand for housing. The 2006 census has shown that the Irish population has risen by 10% in just five years and it should be remembered that housebuilding slowed sharply in the 1980?s, from 28,000 in 1980 to 15,600 in 1988. Consequently, even with the recent surge in supply the total housing stock is still relatively low - around 415 per 1,000 population against an European norm of 435. This suggests that strong housing activity is likely to remain a feature of the Irish economy for some time, regardless of the current cyclical slowdown. The extent of this depends on the interest rate outlook but also the extent of price responsiveness on the downside - completion may fall to around 80,000 this year, and perhaps 70,000 in 2008, in response to the cyclical slowdown in demand. A more rapid reduction in completions, however, is possible, which would dampen GDP growth but also offer more support for house prices.

Dr. Dan McLaughlin
Group Chief Economist

Anne Mathews
Media Relations Manager
Group Corporate Communications
Tel:01 6043836