The economic outlook for the Irish and euro area economies

Last week ECB staff published their latest projections for the euro area and this week we published our latest outlook for the Irish economy.  Let me give some reflections on both.

At our meeting last week, my Governing Council colleagues and I decided to keep the three key ECB interest rates unchanged.  In the latest projections, inflation has been revised down, in particular for 2024 which mainly reflects lower energy prices.  Inflation in the euro area is expected to average 2.3 per cent this year, 2.0 per cent in 2025 and 1.9 per cent in 2026.

The current data we have suggests that measures of underlying inflation have eased further, which gives us more confidence about returning to our 2 per cent medium-term target.  Against this, domestic inflation remains high, in part driven by strong growth in wages putting upward pressure on services prices. This is an area we will continue to monitor closely. 

The projection for economic growth in 2024 has been revised down to 0.6 per cent, with activity expected to remain weak in the near term. Growth is expected to pick up to 1.5 per cent in 2025 and 1.6 per cent in 2026. Given downward revisions to growth, risks to the euro area growth outlook are to the downside in the near term.

In light of these new projections, how do I see the interest rate path?

Given the continued disinflation we have seen and progress on underlying inflation, it’s becoming clear that there is scope for a change in our monetary policy stance, and, specifically, to make it somewhat less restrictive.  I remain open-minded as to when any reduction in our policy rates should take place.  As I have emphasised before, while our data-dependent approach allows us to make informed and timely policy decisions, it also means having an open mind on the rate path, including the need to hold for longer, should progress on returning inflation sustainably to target be threatened by further shocks, or wage growth turns out to be inconsistent with achieving 2 per cent inflation over the medium-term. 

The history of monetary policy tells us that rushed decisions tend to be wrong decisions.  Patience is a virtue.  But waiting for clear and unambiguous evidence is also not realistic and we have to manage the uncertainty and make decisions on the evidence in front of us.  My current view is that the picture should be sufficiently clearer when the Governing Council meets in June (as we will have a lot more information – particularly on wage dynamics – available in our deliberations) to give us sufficient confidence to make monetary less restrictive.

The Irish economy

This week we published our latest Quarterly Bulletin which gives our views on economic and market developments. The domestic economy continues to grow, but weak external demand and domestic capacity constraints are expected to weigh on the pace of growth over the forecast horizon.  Exports produced in Ireland declined in 2023 but should recover this year (and beyond).  Modified Domestic Demand – our preferred measure of the economy – is forecast to grow from 2024 to 2026 by 2 per cent per annum on average, underpinned by continuing growth in consumer spending and residential construction. Developments in several forces currently restraining economic growth influence the outlook out to 2026, namely the transmission of monetary policy, sectoral developments in the pharmaceuticals and ICT sectors and capacity constraints in the domestic economy.

Domestic factors have become the dominant influences on inflation as externally-driven price pressures have faded. The latter is particularly evident in energy inflation.  In contrast, services inflation remains above 5% and is projected to decline only gradually out to 2026. A continuation of declining price pressures for energy and non-energy goods is expected to reduce headline inflation to 2 per cent this year, 1.8 per cent for 2025 and 1.4 per cent for 2026.  More persistent domestic price pressures – as reflected in services inflation – are forecast to result in core inflation exceeding the projection for headline inflation out to 2026.

The labour market continues to operate at full capacity, although employment growth has slowed and growth in the labour force overall is expected to be below its long-run average. The unemployment rate continues to remain close to all-time lows and, contingent on our projections for modest economic growth, is expected to average 4.5 per cent out to 2026.  While broad measures of labour market slack and vacancy rates have eased, the labour market remains relatively tight. These conditions are forecast to underpin nominal wage growth of 4.7 per cent per annum on average from 2024-2026.

Overall, risks to the growth outlook are tilted to the downside, with risks to the inflation outlook broadly balanced.  (By the way, a couple of weeks ago we published our risk outlook and priorities in the area of regulation and supervision.  Macroeconomic and geopolitical drivers, risks from how firms are responding to a changing world and market, and risks driven by long term structural forces at play, all characterise the risk landscape currently facing the financial sector.)

Pass-through of monetary policy in Ireland

For firms, the cost of credit has closely followed the changes in the policy rate.  Interest rates increased by around 3 percentage points between 2021 and 2023, to just under 6 per cent.  Because the largest share of borrowing by Irish firms is at variable rates, interest rate pass-through tends to be relatively quick. This is in contrast to some other euro area countries – notably France, Germany, Belgium and the Netherlands – where a higher share of fixed rate lending to businesses means a more delayed pass-through of monetary policy.  In the closer term, higher financing costs as a result of tighter monetary policy are expected to constrain private investment. 

As for households, policy interest rates have only partially passed through to the 29 per cent of households that have a mortgage, depending to a large degree on whether mortgage rates are fixed or variable.  Interest rates on tracker mortgages have gone up in-line with the increase in the policy rate, while those on fixed rate loans issued before 2022 have experienced little change.  In addition, new borrowers are typically paying between 1 and 2 per cent more than those drawing new loans in 2021.  

As I wrote in my last blog, the resilience of Irish households during this shock has been supported by more than a decade of balance sheet repair after the previous crisis, and prudent new lending under our mortgage measures, as well as by nominal income growth, government supports, and the relatively slow pass-through of monetary policy. 

As for savers, those with deposits in Irish banks saw little benefit from higher policy rates earlier in the rate-rising cycle, as banks were slow to pass on rate rises.  This has changed in recent months, with higher rates on term deposits coming much more into line with similar products in other euro area countries. We have also seen a gradual shift out of low-interest overnight deposits into longer-term savings products.

Conclusion

The fight against inflation is being won with a disinflation process well underway.  But a global environment that is characterised by economic and market uncertainty, rapid technological change, geopolitical tensions and regional conflicts also means that we need to remain focused on managing the risks to the achievement of the monetary and financial stability that our communities want.

Gabriel Makhlouf