Tuesday, 26 October 2010

The Frankfurt dilemna - Ireland, hold on to your hat

So you think Ireland has some significant economic difficulties? Trying to manage our way off an explosive debt and deficit path for both the public sector specifically and the entire country generally is a painful adjustment.

Well, don't look now because things might get worse in the not too distant future. The reason is because short term interest rates might be on the way up before too long if recent trends continue, which if it comes to pass will make our adjustment even more painful and more difficult because the interest charge on the country's massive debt stock will rise too. Note that most of Ireland's total debt is subject to a variable, or short-term interest rate largely due to the concentration in variable rate mortgages of some description or another.

But why would interest rates increase? Surely it doesn't make sense. Well, tell that to those humourless suits at the Bundesbank who watch monetary aggregates like hawks. Those influential central bankers know that money supply figures have passed a clear turning point that means we should be ready to tighten monetary policy from its current sluice gates open mode.

Exhibit #1 - Monetary aggregates

M1 is narrow money, mostly notes and coins in circulation. M3 represents wider demand and interest bearing deposits in banks. Note what has happened to both in recent years. Before the full onset of the Global Financial Crisis (GFC) M3 was rising at a generous pace. People were borrowing from banks, that borrowing circulated back via economic transactions into deposits in banks. The Lehman Bros happened, at the point indicated in the chart. Initially it led to people putting wealth into cash (so M1 increased with an immediate spike) and then the ECB began cutting interest rates, promoting further growth in narrow money. M3 virtually stalled, as people didn't want to leave wealth on deposit with banks and the borrowing and deposit (known as money creation) cycle collapsed.

So this state of affairs continued. Until earlier this year. While M1 is still rising as monetary policy remains lax and interest rates remain low, M3 has started rising. The money creation process appears to have been rekindled. That is good news, because a continued downward money supply (M3) spiral would be a harbinger of deflation. However, it is also ominous in the sense that it indicates that the type of emergency low interest rates and lax monetary policy (including generous ECB repo lending and open market operations - e.g. Irish government bond purchase) may not be deemed appropriate any longer. That means higher ECB reference rates (the Refi. rate), which in turn will push up interbank rates and hence lead to higher retail rates, especially (say it softly) tracker and variable mortgage interest rates in Ireland.

Exhibit #2 - Euro monetary aggregates recent rates of growth

This chart shows the most recent rates of growth, annualised rolling quarterly growth rates. M3 is now growing for the first time in over a year and not much below 5%, which would be within a range considered to be consistent with the long term inflation target of the ECB - 2%.

Exhibit #3 - Euro monetary aggregates annual growth rates

Even the annual (year on year) rate of change of M3 has turn positive, while M1 is growing at rates that would only be acceptable for short periods of time.

Ireland had better watch out, because nobody seems to be talking about this big smelly elephant at the moment.

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