Interest rates will remain high, even as the ECB starts cutting

Interest rates are – finally – coming down, with the European Central Bank (ECB) starting out today on the long road to reductions with a quarter point cut after ten increases since summer 2022.

Yet while mortgage holders and other borrowers will justifiably hope for more cuts as the year goes on, there are two things they need to realise. First, the signs are that the pace of cuts from here on may be slow enough, unless the euro zone inflation figures start to head downwards again. The second – and related – point is that there is no going back to the pre-2022 days of a decade of super-low interest rates which followed the cut in the key deposit rate to zero in July 2012 in the wake of the financial crash.

The long road to lower interest rates:

Recent history has taught us that financial market expectations of future interest rate trends can change quickly – and dramatically. So it is wise to only read so much into the global change of recent months. But it has been notable. A series of US interest rate cuts had been anticipated this year, but as inflation figures remained stubbornly high and US economic data was stronger than expected, these expectations have changed significantly. This has hit the US stock market, though in the odd world of markets where bad news is good news, there has been a revival in recent days as relatively weak jobs market figures again renewed hopes for interest rate reductions. Still, most forecasters believe that the US Federal Reserve Board – the Fed – will not reduce interest rates until September and are pencilling in just two cuts this year, with some seeing a risk of just one reduction and optimists hanging on for three.

This US mood has sparked a discussion on whether US and euro zone rates could diverge, but the ECB has indicated that it will be influenced by euro zone data. Despite a rise in euro zone inflation to 2.6 per cent in May from 2.4 per cent in April - and an increase in the ECB’s own inflation forecast for this year to 2.5 per cent - the central bank has gone ahead with a quarter-point reduction. The inflation data and some signs of life in the euro zone economy – where wage growth is running at 4.7 per cent and unemployment remains low – have led to traders asking how much further interest rates will fall as the year goes on. And this is obviously important for tracker mortgage holders in particular, who have experienced a 4.5 per cent rise in borrowing costs since summer 2022, as the ECB refinancing rate, from which trackers are priced, rose from zero to 4.5 per cent and has now just edged down to 4.25 per cent.

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So how much might ECB rates fall this year? Financial markets are now betting on another two reductions after today’s. This would still leave the ECB’s key deposit rate, now 3.75 per cent, at above the 3 per cent mark by the end of the year. This is important because at this level interest rates are still in what the ECB sees as “restrictive” territory – in other words enough to keep a lid on lending and, it hopes, keep inflation on the way down. Were inflation to head gradually down towards the 2 per cent level by the summer of 2025, it would allow interest rates to continue to fall into next year. Were inflation to stay high, however, this outlook could be upset and after a couple of cuts the ECB might have to stay put for a while. Managing these interest rate expectations, which in turn have an impact on the economy, will be important for the ECB as this in turn will affect its fight against inflation.

The longer-term perspective:

What matters most for mortgage borrowers is where interest rates are in the longer term. And there is one key message to understand. Mortgage rates are not returning to where they were before the recent increases started – barring some big collapse in the euro-zone economy. Perhaps some time in the future this may happen. But the rock bottom interest rates of the previous decade came during a period of low euro zone growth and inflation which was below the ECB 2 per cent target level. Now the expectations are for inflation to remain at or above 2 per cent for the foreseeable future. And so interest rates which banks charge will not return to the levels which saw many tracker rates prices at 1 to 1.5 per cent and three to five year fixed rates of 2.5 per cent or less.

The argument around how far interest rates might fall rests in part on a theoretical argument about the so-called natural level of rates – the level at which they neither stimulate nor restrict economic activity. In turn this natural rate has to take into account the rate of inflation at that particular time – in other words it is expressed as the real, or inflation-adjusted, rate. There is no way to observe what this is exactly and recent estimates for the euro zone range from a natural rate slightly above inflation to one slightly below. In other words, if the ECB were to achieve its 2 per cent inflation target, interest rates might in time fall towards this level, or certainly towards 2.5 per cent, but would only fall lower if the rate of inflation dropped below the 2 per cent target.

So one possible outcome is that interest rates fall gradually in the months ahead but that the ECB deposit rate only drops below 3 per cent next year. If, say, it fell to around 2.5 per cent, this would imply tracker mortgage rates in the 3.5 to 4 per cent rate range, compared to more than 5 per cent now. This remains well above what many tracker holders were used to. However, as their repayments were lower over the years than other mortgage holders and the average outstanding balance is now €100,000, most of this group are well into their loan and are unlikely to end up in financial difficulties. ECB rates of 2.5 per cent or so also suggest that the better fixed-rate offers on the market, now in the 3.5 to 3.75 per cent range, are not bad value, though the remaining fixed rates of more than 4.5 per cent on offer from some lenders are poor value in this context.

So borrowers who took out new mortgages or rolled off fixed-rate loans over the past year and decided to go variable or take a one year fixed have benefited as the fixed rates now on offer have improved and some should be cut further.

[ ECB rate cut to breathe fresh life into euro-zone economy ]

The Taoiseach’s call:

Taoiseach Simon Harris let it be known this week that he would be telling lenders to respond to the ECB cut. This is largely performative as some interest rates have been cut already as the markets anticipated the ECB move and tracker rates will fall automatically. In terms of variable interest rates and fixed rate offers, most did not increase in tandem with ECB rates – and some have been reduced anyway. It is no harm to keep pressure on the lenders, but as its shareholding in the banks reduces, the Government has less clout in this regard and competition law means banks cannot signal what they plan to do. One place the Government might direct its fire is towards the nonbank lenders who are managing loans owned by investment funds, where interest rates have remained punishingly high in some cases. Those borrowers with these loans can rightly feel let down by the authorities – who promised them that they would not be disadvantaged.

It is also worth remembering that tracker holders will get a “ bonus” cut of 0.35 of a percentage point in September, due to a restructuring of ECB official interest rates. At the moment there is a half point gap between the main rate – the deposit rate – and the refinancing rate, from which the price of tracker rates is set. The ECB announced that this gap was to be closed to 0.15 of a point for technical reasons; the resulting reduction in the refinancing rate will knock on to lower tracker rates.