Interest rates are again in the headlines as the Fed, the Bank of England and the ECB all had meetings. It may be a little known point but in the past there was some currency co-operation, namely the Plaza Accord and two years later the Louvre Accord and although there is no official ‘strategy’ we may start to notice that central banks act with at least some degree of collusion as they try to solve global economic issues. That last sentence might confuse, on one had interest rates are not connected to currency strengths but interest rates do have an effect on inflation and inflation can be brought about by currency manipulation (namely having too much in supply).

The Irish rate of inflation thus far in 2008 dropped from 5% in June to 4.4% according to the Central Statistics Office (CSO) the article in the Times didn’t mention if this was headline or core inflation. It has been our belief for some time that Central Banks would leave rates as they are and wait until they could see which direction the inflation/recession figures played out, on one hand inflation can not be allowed to run free but on the other there is a risk in killing inflation because that can spread over to output which would worsen the economy. The patter we believe central banks will take is that of ‘watch and wait’, inflation will either come under control as economies tighten or it won’t if it does we may later see a rate cut if it doesn’t then we will witness a rate increase.

What does this mean for mortgage interest rates? For those of you on fixed rate mortgages it doesn’t mean much in the short term, for people on tracker mortgages or variable rate mortgages it will mean your payments will increase or decrease. Having said that, people on variable rate mortgages have been forced to deal with much higher margins than in the past as lenders increase their variable rates in order to make up for losses they have been taking on ECB tracker mortgages. This occured because the margins got too low to sustain when the Euribor rates became disassociated from the ECB this is one of the symptoms of the ‘credit crunch’.

The Bank of England also left rates unchanged at 5%, the Fed followed suit leaving rates at 2%. In our opinion this shows that central banks are adopting a ‘wait and see’ attitude towards inflation. There is a fine balance between inflation and rates, while the ECB should (if they wanted to knock inflation instantly) raise rates in order to dampen inflation they have to weigh this against the impact on the general economy which could destroy any growth hopes. That is why they are going to sit it out for a while and see if the economic downturn erodes inflation and to what degree, if it doesn’t happen we will see a rate hike, every economist out there has written off this possibility but we still feel that the ECB will never keep a rate increase off the cards.

For those who love predictions the way we feel this will play out is as follows: The dollar is getting stronger, this means that the GDP in the Eurozone may rise as exports to the USA become cheaper for Americans. This could hamper a fall in inflation, and because it will be uncertain as to how this effect is realised it will mean that the ECB will continue to wait and see, it takes several months for any change to play through the economy, because of this there will be strong talk (as always) about inflation, but an increase in the talk about ‘downside risk’. At a point before Christmas this talk will prompt (assuming inflation is falling) an indication of a rate decrease in early 2009, but again, if we don’t see inflation fall then rates holding or even increasing is a strong possibility.

Another risk is if any ‘pay increases’ are successful (across Europe) because that will drive inflation as well and lead to embedded inflation which will mean a rate hike is still possible, on that front we feel that increased wages are not to the greater benefit, a change in minimum wage would be better as the Union organised increases are primarily going to go to the public sector who are not the members of society most at risk.

Our over-riding feeling is that the speed of the drop in inflation versus the economic growth will determine the rate change and if we are to expect a change it will be either 0.25% in mid 2009, or if the momentum is too great (if sentiment and activity drop too quickly) perhaps even 0.5% of a drop at that point. The only thing that would counteract this would be if inflation doesn’t come under control and if that’s the case then rates are likely to remain stagnant until Q3/4 of 2009.