The Three R’s: Russia, Rates and Recession
Alan McQuaid
Independent Economist

Alan McQuaid is a leading economist and media commentator. He has previously worked with the Department of Finance and several Irish firms including both Merrion Stockbrokers and Cantor Fitzgerald Ireland.

The three Rs; Russia, Rates and Recession are dominating the economic discourse at the moment. The world is paying a heavy price for Russia’s war in Ukraine. When coupled with China’s zero-COVID policy, the war has set the world economy on a course of slower growth and rising inflation – a situation not seen since the 1970s. Before the war broke out, the global economy was on track for a strong, albeit uneven, recovery from the pandemic. According to the OECD’s latest economic projections, world GDP growth is now forecast to slow sharply this year, to around 3%, and remain at a similar pace in 2023. This is well below the rate of recovery projected at the start of 2022. Growth is set to be markedly weaker than originally expected this year in almost all economies.

Inflationary Pressures Have Intensified

The EU Harmonised Index of Consumer Prices (HICP) for Ireland is estimated to have increased by 9.6% in the year to July compared to an annual increase of 8.9% in the Eurozone. It is set to hit 10% plus in the coming months. A gradual reduction of supply chain and commodity price pressures and the impact of rising interest rates should begin to be felt through 2023, but core inflation is nonetheless projected to remain at or above central bank objectives in many major economies at year-end. It is not a question of when inflation will peak but rather where will it settle when it eventually bottoms out again. My view is that it is unlikely to go back to the 0-2% range and will more likely hover around the 2-4% range over the short to medium term, which will have implications for official interest rates and bond yields. The bottom line is that we are unlikely to see a return to negative/zero yields for the foreseeable future. The Irish 10-year bond yield is likely to move in to a 1.5-2.5% trading range in the coming months.

ECB Response Has Been Slow

Whilst most of the major central banks have been quick to respond to the rise in inflation, the European Central Bank has dithered. It has been a long time coming but eleven years after it last raised official interest rates, it got its tightening cycle under way in July and is set to announce further rate increases at its September, October and December meetings. Depending on what happens on the inflation front between now and year-end, the total hike in official rates in 2022 will be somewhere between one and two percentage points, which will have huge implications for both businesses and households. Official rate increases by the ECB will likely mean that 460,000 Irish home loan borrowers on variable and tracker rates of the 740,000 residential mortgage borrowers in the Republic will see an immediate rise in the costs of servicing their home loans. Almost all 740,000 borrowers will in time pay more, as the remaining borrowers on short-term fixed mortgage rates revert to new and higher borrowing costs. It is estimated that even just a half-point increase in rates will add €80 a month, or €960 for a full year, to the cost of households servicing a mortgage of €300,000. Irish mortgage rates remain the second highest in Euroland after Greece and more than a percentage point higher than the Eurozone average.

Irish Economy Weathering the Storm Better Than Most

There is a global risk of recession, but Ireland is in a relatively good place due to its reliance on digital and farming, and lack of reliance on Russian energy. Ireland’s domestic economy contracted 1% quarter-on-quarter in the first three months of the year on the back of declines in personal consumption, government spending and investment and the first signs that rising inflation was starting to bite. Gross domestic product (GDP), a broader measure of economic activity, grew by 6.3% on the quarter, by far the fastest rate in the EU. However, statisticians have long cautioned against using this measure due to the ways Ireland’s large multinational sector can distort it. Officials instead use modified domestic demand (MDD), which strips out some of those distorting factors. That was 12.6% higher than the same period in 2021 when the economy was in strict lockdown. The Central Statistics Office (CSO) said growth in the multinational dominated sectors was the main contributor to the quarterly jump in GDP, which followed a quarterly fall of 1.7% in the often-fluctuating series during the final three months of 2021. The quarterly contraction of 1.0% in MDD in the opening quarter of 2022 needs to be considered alongside very strong jobs numbers, with the unemployment rate back to its pre-pandemic level below 5.0% at 4.8%. Other recent economic indicators including new dwellings completed and booming tax returns also paint a rosier picture, though rising inflation is likely to seriously dampen economic activity in the second half of the year.

Budget Day Package Of €6.7bn On the Cards

The Government’s recent Summer Economic Statement shows the Budget will contain spending and tax measures equal to €6.7bn. The Budget, which will take place on September 27 – two weeks earlier than planned – will involve €5.65bn in spending and just over €1bn in tax measures. Spending next year will increase by 6.5%, in what has been described as a “temporary once-off increase,” which breaches the Government’s own spending rule of 5%. Of the total Budget Day package of €6.7bn, €3bn will be allocated to maintain existing levels of public services.

The boost to tackle the fallout from inflation is underpinned by exceptionally high corporation tax receipts. They were €3bn or 53% higher in the first half of this year compared to the same period in 2021. Even with the additional expenditure, this level of corporation tax is expected to help the public finances record a modest surplus of just over €2bn this year and next year. Without it, there would still be a significant deficit.

The Budget needs to focus on protecting the less well off in society and not a one-shoe-fits-all approach. The prudent thing to do from a fiscal point of view would be to reduce the tax burden for lower income individuals/households and raise it for those earning above €100,000. Ironically, that is probably an approach a Sinn Fein led government would take but it is unlikely to happen under the current coalition. At the end of the day, maintaining safe public finances is very important as there may be further challenges down the road.

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