As the Central Bank publishes a major report today examining the dangers posed by rising house prices, Marc Coleman assesses the outlook for interest rates and the property market.
Some time before next spring the European Central Bank will raise interest rates for the first time in over four years. When this happens it will mark the beginning of the end for an era of cheap credit. During that era, Irish house buyers and borrowers have between them managed to push up debt levels and house prices to unprecedented levels. The question is; with rates rises in the offing, are house prices now set for a long-awaited fall?
In its short history the ECB has hiked rates only once before and that was in 1999. A powerful combination of economic growth, supply constraints and surging demand acted to ensure that, far from falling (or even stalling), house prices kept surging. That was then.
This is now. Two important factors have changed since 1999. The first relates to economic and financial conditions facing borrowers, the second to housing market fundamentals.
Although Ireland's economic performance is still the envy of Europe, it isn't what it was in 1999. It is now more moderate and less characterised by consumer strength. In 1999 personal consumption was surging. House buyers could bid up house prices without unduly constraining their ability to purchase things other than bricks and mortar. The level of consumption now is more subdued - partly due to a higher savings rate (thanks to SSIAs). But this is also due to the fact that the financial position of borrowers is more constrained. Newer borrowers are especially more vulnerable, with many having put themselves to the pin of their collar. A one percentage point increase in mortgage rates will see many borrowers suffering a higher proportionate cut in personal income than was the case in 1999.
Market fundamentals have also changed. Supply has increased phenomenally while both investor and owner-occupier demand is dampened somewhat by falling rents. In addition, concerns about some apartment blocks - together with a rising quality of supply - have created a more discerning buyer with the possibility of a flight to quality affecting prices in certain sectors of the market.
In short, the property market is not as robust now as in 1999 and may be stress tested by significant rate rises. But what do we mean by significant? Most media speculation about an ECB rate rise has to date concerned the question of the timing of the next rate rise. For the housing market the question of a quarter or a half per cent increase in either December or March is neither here nor there and should be left aside. The real issue is by how much rates will rise over the tightening cycle and how long that cycle will last.
Looking at the evolution of the ECB's base rate since 1999, what is noticeable about the bank's first tightening is its rapidity. Base rates increased by three percentage points in the space of just one year. If such speed was repeated, average mortgage repayments could rise by at least €300 a month by the end of 2005. This would shrink the capacity of new entrants by between 10 and 15 per cent. It is not hard to conceive falls in property prices under such circumstances.
The possibility of the ECB repeating such brutal speed is remote, for several reasons. In late 1999 and 2000 the European economy was booming and inflation was a greater concern than now. Moreover, the ECB was then an unknown quantity with a reputation to build. Europe's present recovery is, by contrast, a rather tentative affair and inflation prospects are so far modest due to euro strength. Since then the ECB has also established a reputation for being tough - too tough according to some.
Since the first bout of rate hikes, the ECB has been slower and more paced in reducing rates. A traditional central banking mentality of circumspection and consensus has replaced the missionary zeal of earlier times. This more measured pace is likely to be maintained as rates move back upwards.
In my view, therefore, Irish mortgage holders can prepare for a soft landing as rates increase gradually over the next two years. Indeed with growth in employment and real incomes set to pick up strongly in 2005 and 2006 further growth in house prices is likely, albeit at a more modest rate than before.
But we are not out of the woods yet. A risk to the housing market does exist. It is a slight one but worth identifying nonetheless - if only to underline some important policy risks and challenges in the years ahead.
The positive impact of SSIAs has already been noted in this article: it is likely they have encouraged a welcome tendency to save money. But with them being released back into the economy in 2006, they may considerably raise the leverage of those wanting to trade up in the housing market or help offspring to enter it. The fact that our economic cycle is likely to peak in 2006 and that tax reductions are likely to occur in the coming years will provide further support to house buyers.
Taking this into consideration, the Irish property market will on average be "safe as houses" until 2006. I say "on average" because some low-quality segments of the market may suffer from a flight to quality as the supply of newer and higher quality apartments increases.
But a risk remains beyond 2006. If growth in Europe continues to be weak, then the full force of forthcoming ECB tightening may be delayed until 2006.
If by then economic conditions have caused house price growth to lose touch with fundamentals, then the risk of house price declines will become very real.
The EU country with the most similar housing market to our own, the UK, has used its own monetary policy to steer a safe landing for its property market after several years of strong house price growth. However, we will have to consider what alternative instruments we can use to help secure stability and security in our housing market and economy.
Marc Coleman was until August an economist with the European Central Bank and is now on scholarship at the Michael Smurfit Graduate School of Business