The move, while not favoured by borrowers, is vital in order to control Eurozone inflation which has been running well above the ‘at or just below 2%’ level that the ECB has intended to adhere to. In the first quarter of the year many commentators were saying that they believed we would see a rate reduction in the summer, this blog on the other hand argued otherwise in articles which were posted in mid March and again in mid April. As recently as May professional commentators (our crew is more along the line of humble observers!) such as Simon Barry from UlsterBank and Austin Hughes in IIB said that they feel rates will remain the same or drop. Perhaps one concern we should have in the Irish economy is that respected professional commentators are misinterpreting events, the danger in that respect is that business decisions are being based on this information and when its wrong the decisions are wrong and that has a knock on effect.
How could this affect you? Joe Public? Well, imagine that you were getting a mortgage and wanted a fixed rate, a lender or broker might say ‘the predictions are that rates are going to come down’ and for that reason they advise not getting a fixed rate because you would potentially be paying more for the loan if you bought a fixed rate right before rates dropped. The precise problem in the Irish market was that lenders have pumped up rates even though the ECB didn’t move their rates, and now that they have, variable rate holders will be getting hit with that increase as well, so it’s a double whammy and that is the price of getting it wrong.
The reason we believed this is that inflation figures were running too high and could not be ignored, that, coupled with agflation and rising oil prices meant that the only way to reign in inflation would be to deliver a rate increase. Inflation by nature is easier to prevent than to try and recall, the US Fed will have some testing times ahead for that very reason.
Lenders here are expected to pass on the rate increase to borrowers. The average mortgage holder may be forgiven for thinking that ‘rates were going up’ all along because every lender had increased their interest rates in 2008. The reason for the lender increases had nothing to do with the ECB base rate, instead it was based on the EURIBOR (European Inter Bank Ordinary Rate) prices which were and still are at historic highs. In a healthy economy the Euribor would generally be
[Base Rate] + 0.1 – 0.2%
A bank would buy money at that price and then lend it on, but since the dawn of the credit crunch and liquidity crisis money is not available and any that is carries a high premium so Euribor rates have been closer to the 5% mark for quite some time despite the 4% base rate, of course, with today’s increase we will see those rates go up by 0.25%. If core inflation comes into check then perhaps this rate increase will be the last in the series of rate increases that we saw beginning in December 2005. The balance and the difficult job of the ECB is to find that balance between inflation and growth, so far they have done a good job but perhaps we will now see the point reached whereby inflation falls off but growth does too.
In order for a rate increase to take effect through the economy it will take at least three months and maybe as long as a year. If the economy does not respond to the 0.25% raise then the ECB would likely be faced with having to consider a further increase, however, in looking at general sentiment – check out the headlines of national papers around the EU – you will see that everybody is tuned into what is happening so we will likely see the 0.25% raise in the base rate have a similar effect to a 0.5% raise for the simple reason that everybody is so focused on the rate market.
The economy is facing a challenging time, yesterday €2 billion was wiped off the ISEQ and meanwhile that oil inflation mentioned earlier made headlines too as the barrell price reached $146. This is raising concerns over employment costs, the ‘stagflation’ period of the 1970’s happened in a time where labour prices rose in order to meet the inflationary environment, today it will be vital for labour costs to be kept in check or we may face the very real risk of embedded inflation, further rate increases made to stave off inflation, and then the stagnant or decreasing GDP bringing about that dreaded stagflation environment.
For now we will have to wait and see what the effect is of the ECB rate change and how the EU economies react in the short term.