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Has the ECB now paved the way for higher interest rates?

Smart Money: Ukraine war has pushed up inflation and central banks are under pressure to act

Before the war broke out in Ukraine, interest rates were only heading one way – upwards. Now central banks are in a bind, facing the risk of higher inflation but also an economic shock from soaring energy prices. Inflationary pressures usually point the way to higher interest rates, but by implementing this, central banks could worsen a potentially big economic hit from the war. So what will they do? And what will it mean for Irish borrowers and savers?

1. The background

Before the invasion, the expectation was that there would be a steady upward march in international interest rates this year, led by the US Federal Reserve and the Bank of England. The ECB was expected to follow more slowly, with the markets betting that it would end its special pandemic bond purchasing programme later this year and increase its deposit rate, now minus 0.5 per cent, to around zero. This was seen as paving the way for increases in its key refinancing rate next year. For Irish mortgage borrowers this would have meant that variable interest rates and some fixed rate offers would have started to edge higher this year. However tracker rates would not have started to rise until 2023, as they are tied to the refinancing rate. But now what?

2. Changing expectations

In the immediate aftermath of the outbreak of the war, interest rate markets swung dramatically. Talk of a half point increase in US interest rates in March was trimmed to a quarter point and market prices reflected uncertainty about whether ECB rates would rise this year at all. Long-term market interest rates fell sharply.

However in recent days, perhaps due to rising inflation forecasts, markets have started to price in interest rate rises again, with five quarter point hikes anticipated from the Fed this year, a steady rise in UK rates and an increase in the ECB’s deposit rate of at least a quarter of a point this year. European rates would remain very low, but the trend will have turned by the end of this year, if these forecasts are correct.


In its announcement after a meeting of its governing council on Thursday, the ECB said it was going to run down its bond buying programme, which supported borrowing through the pandemic, slightly earlier than anticipated. This leaves the way open for interest rates to start rising later this year. ECB president Christine Lagarde revealed that there had been different views on the ECB council about what to do.

But the decision to press ahead and end the stimulus programme led to speculation in the markets that the monetary “hawks”, concerned about inflation, had the upper hand. The ECB has left some room for manoeuvre on the timing of its first rate hike, just saying it would happen after the stimulus buying programme ended., without indicating any timescsale. But longer-term market rates are edging up again and if this continues it will start feeding into some of the fixed rates being quoted to Irish borrowers before too long.

3. The economic argument

The discussion on how fast central bank interest rates should rise has been underway for some time now in the light of energy price rises. It is not a simple one. In a speech this week to the Hertie School in Berlin, ECB chief economist Philip Lane outlined the key arguments. He pointed out that the vast bulk of the inflation increases seen in the euro area had been due to energy – where prices have risen 32 per cent in the last year and are still going. This also had indirect effects, as businesses passed on higher energy costs to consumers. He pointed out, however, that this could be seen as a once-off increase in the level of prices, rather than a price rise trend that could recur. Pandemic price pressures due to messed up supply chains should also ease, he said. There is an argument that because inflation is not being caused by a rise in demand, higher interest rates are not the ideal weapon to fight it with.

Lane then went on to look at the debate on what the ECB should do. He said that on one side of the argument there was the “cost of waiting too long” – of not moving quickly enough to try to bring down inflation. A key issue for central banks is the expectations of the public and businesses about inflation. We have got used to low inflation – which has been below the ECB 2 per cent target for years – but as prices now shoot higher, does the public still trust the ECB to get inflation back to this level after temporary factors have passed? This is vital, because if they do not, then this will quickly feed into wage demands and a general, self-fulfilling, expectation of a permanent rise in inflation.

Lane then outlined the other side of the argument. If most of the factors pushing up prices are temporary and forecasts show it reverting to the target level over a period of time, then pushing up interest rates too quickly would be counter-productive and could in the longer term drive inflation back below the ECB’s 2 per cent target. Despite this, the latest indications from the ECB appear to suggest that a deposit rate increase later this year is more likely than not,

Central bankers must navigate a really difficult path here and it is a big issue of debate internationally. In the US, in particular, senior economists such as former treasury secretary Larry Summers argue that the Fed pumped too much cash into the economy over the pandemic and that this will increase the cost of getting hold of inflation over the next couple of years. In other words, they believe that the Fed will have to push up interest rates in a way that hurts the US economy more than if they have moved more quickly.

4. Irish trends

The latest figures in the Republic show that the average interest rate for new mortgage loans in January was 2.76 per cent, more than double the euro zone average of 1.31 per cent. Calculations by show that this adds €2,200 to the annual cost of a typical Irish mortgage.

While the average Irish rate has come down over the past year, it is up from 2.69 per cent in December. With market mortgage offers not increasing, Darragh Cassidy of says that the increase in the average rate paid by new Irish borrowers is likely to be due to more deciding to take longer-term fixed rate loans, which tend to be a bit more expensive. This trend follows speculation that interest rates are on the way up. As we have seen, the pace and timing of interest rates is now in question.

Housing market demand is strong, with mortgage drawdowns up 22 per cent in volume terms last and 25 per cent in value terms. A 30 per cent rise in mortgage approvals suggests continued strength into 2022. Of course the unknown factor now is the impact of the war on Ukraine on economic growth and confidence, as well as interest rates. A slowing in growth and consumer spending power is certainly likely, but with housing supply still constrained, prices should remain firm in short term at least. Beyond that we will have to wait and see how this all plays out.