Cliff Taylor: What permanently low interest rates mean for you as a saver or borrower

There is no prospect of interest rates increasing over the next couple of years or – and probably longer – as the Covid-19 crisis plays out. But something else is changing,too.

Since the late 1980s interest rates have been on a general downward trend. For those taking out mortgages, or trying to manage savings, the message is that rock bottom interest rates now look like being the new normal, with huge implications for personal finances.

The entry of Avant Money to the Irish mortgage market this week underlines the changing picture for those taking out homeloans.

At some stage recovery will come and European Central Bank rates may rise, but the peak to which rates might go in any cycle for the foreseeable future remains very low. For borrowers, savers and investors, the world was already changing before Covid-19 and now there is no going back.

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1. The big picture.

ECB chief economist Philip Lane, who used to head the Irish Central Bank, spelled out the longer-term picture in an interesting address to the recent Dublin Economic Workshop. The underlying picture is of a long-term downward trend in interest rates which shows no signs of reversing.

Lane looked at what you might call a normal level of interest rates – a level which would keep the economy in balance when it was growing at an average rate. He related this to the rate of inflation. In the jargon this is the underlying real rate of interest – how far nominal interest rates would be above inflation. This has been falling since the 1980s, he pointed out, as world economic growth has slowed and also due to an ageing population and some other factors.

After the euro was launched in 1999, Lane said the the underlying real rate was around 3 percentage points. So adding this to the ECB target inflation rate of around 2 per cent left new mortgage rates to consumers generally over 5 per cent.

By the time the financial crash came in 2008, interest rates were already trending lower in real terms. By then, on Lane’s estimates, the underlying real rate had fallen to 2 percentage points. So when inflation was at the ECB target of 2 per cent, interest rates would be at around 4 per cent.

Now, Lane says, the underlying real rate of interest is at 0 per cent, or possibly even slightly below. What this means is that even if the euro zone economy recovers in the years ahead and the ECB succeeds in its target of getting inflation back close to 2 per cent, then we might expect nominal interest rates to be at around the same 2 per cent level. Of course they might rise higher were inflation and growth to surge at some stage. But the top of the interest rate cycle is now much lower than it was.

2. Why has this happened?

Many learned papers have been written about this. The ageing population in many countries is a key reason, Lane said. Older people save more – particularly through pensions – and this provides a big supply of cash. Some of this saving will now be channelled into buying government bonds to help pay the price of Covid-19 government spending. There is, as Lane put it “ a lot of savings in the world.”

The savers are also nervous to invest, scarred by the financial crash, particularly in equities.

This combination of high savings and low investment pushes down the required level of interest rates. Business investment is also low and the world seems to have entered a phase of lower economic growth as productivity increases slow . Ireland’s post-Covid crash growth rates were very much an exception internationally.

It all points to lower interest rates being here to stay.

3. What it means for borrowers?

After the financial crash, a number of banks pulled out of the Irish market. Since then, new competition has been slow to arrive and this has been a factor keeping interest rates high for borrowers.

The arrival of Avant Money into the mortgage market this week, backed by Spanish bank Bankinter, is the kind of competition which had been expected to arrive on our shores earlier.

The new player is offering a headline 1.95 per cent fixed rate for up to seven years, though this is only available to those with a deposit – or existing equity – of 40 per cent or more of their loan.

For those with a 20 per cent deposit the fixed rate would be between 2.35 per cent and 2.65 per cent, moving to a variable rate of 2.75 per cent.

In terms of new competition this offers bigger advantages to some switchers – with equity build up – than to first-time buyers, though for the latter group it is still very competitive.

Bonkers.ie points out that Ulster Bank and KBC already offer 2.3 per cent for a two-year fixed home loan. Home buyers will also want to factor in the cash back offers from some existing lender into their calculation. Avant is competing purely on price – a welcome development as this is the real indicator of longer-term value.

The entry of a new player is important and has already led AIB to trim its fixed rate offers. It will continue the gradual competitive momentum which has edged rates lower in recent years – and there is a distance to travel as average mortgage rates here of 2.82 per cent are still the third highest in the euro zone.

Fixed rates accounts for around three quarters of all new mortgages at an average rate of 2.67 per cent.

Ideally competition would drive this average down and also make longer term fixed rate loans available more widely for 10 years or more, as is common in Continental EU markets.

News that NatWest is considering the future of its Ulster Bank operation in the Republic could, however, be a blow to competition and shows the long-term pressures facing Irish banks

Irish rates remained stuck above those elsewhere in the EU after the last crisis as competition all but disappeared from the market.

The impact of a high level of arrears and loss-making tracker loans on bank balance sheets was blamed – and no doubt had an impact , as did capital regulations obliging banks here to have a higher portion of their assets in forms that could readily absorb losses.

Yet why more foreign banks have not entered to try to cherry pick parts of the market has been a bit of a mystery – the small size and cost of entry to the market has probably been a factor, as has the the lengthy process of repossession when a loan gets into default.

Now the competitive reaction from others to Avant’s arrival show that whatever the peculiarities of the Irish market, there is scope to lower costs to customers.

The prospect of a prolonged period of super-low rates , now being underlined by the Covid-19 shock, should keep borrowing rates under downward pressure.

5. And what about savers?

The new era for savers and investors is very challenging. The rate of inflation is low, meaning the value of savings is not eroded rapidly as would have been the case in the past. But getting any kind of return at all is very difficult – just look at the decision of investors to buy government debt at lower or negative interest rates.

This is a problem for banks as they now face a negative interest rates when they leave cash with the ECB . This is now being passed on to big corporate customers, including pension funds.

If you are in a company pension fund, the portion of the fund invested in cash will be declining each year when you take into account charges and the cost to the fund manager of holding cash.

So far the negative ECB rate paid to banks depositing cash has not been passed on generally to individual bank customers – though Bank of Ireland did write to a group of investment and pension trustee firms in July to say it would apply a negative rate on their cash holdings.

This will in effect be an additional charge on many funds, including small self-administered ones, according to Liam Ferguson of brokers Ferguson and Associates.

And where next ? “ The banks say that they have been applying negative interest rates on deposits for large institutional and corporate customers since 2016,” said Ferguson, “but that is one step closer to the prospect of banks charging personal account holders for holding their money”.

The prospect of rates staying at super low levels for the long term means no relief is in prospect for savers. Ferguson points out that for pension savers it means cash should only be seen as a short-term home for funds and not a long-term investment strategy.

And banks will increasingly look at ways to increase charges. AIB had previously exempted those with quarterly balances of €2,500 in their current accounts from maintenance and transactions fees, but from November they will have to pay.

From the traditional banking approach of trying to attract as many deposits as possible, banks will now want to discourage large cash holdings and persuade customers to move money into fee-based investment products.

In a world where rock bottom interest rates are now the norm, rather than a transient phase, the dilemma for savers is how much risk they are willing to accept to get a return.

The era of compound interest delivering on cash holdings is over.