How high could interest rates go? Fasten your seat-belts

Interest rates are going up again next week. The European Central Bank announced last October that it was giving up forward guidance – indicating to the markets and consumers where interest rates were going to go in the months ahead. Its president Christine Lagarde said it would instead be taking things “meeting by meeting”. So how come a string of its governors have been out in recent days saying they expect a 0.5 percentage point rise next week and the same in March?

This communications confusion may reflect some differences of view in the ECB in recent months – but it is clear that the balance of opinion on its governing council is now firmly towards a succession of further interest rate increases. And this could leave interest rates four percentage points higher this summer than they were when the increases started last July.

The difficulty for the central bank is that the outlook for inflation is now unclear and euro zone growth is falling away sharply, even if the worst fears of a big recession look overplayed. The risk is that it goes too far, hiking up interest rates successively and taking a big toll on growth in the euro zone economies. This is all to try to shake out an inflationary threat that didn’t come from booming growth and demand in the first place, but rather from supply shocks following the Covid lockdowns and the war in Ukraine. In any case inflation may ease sharply this year, with wholesale energy prices continuing to fall for now.

The rhetoric from the governors of the EU central banks who sit on the ECB’s council is stark. Irish central bank boss Gabriel Makhlouf said this week that he believed that interest rates would need to go up another 0.5 of a point next week and the same again in March. His Dutch counterpart Klaas Knot referred to the need for a “constant pace of multiple 50 basis points hikes”. Seasoned ECB watchers say that a bandwagon seems to have developed for a big hike in interest rates. But is this now being driven more by dogma than data?

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How high could interest rates go? It is a case of fasten your seat-belts, it seems. The ECB’s deposit rate is now at 2 per cent and it appears the intention is to get it to 3.5 per cent by the middle of this year. The more hawkish members of the council will push for three half-point rate hikes at the next three meeting, the third of which is in early May – and perhaps even more thereafter. That will knock on to big increases for tracker mortgage holders – and a complete repricing of the fixed and variable home loan market here. Interest rates may still be low by historical standards, but the scale of increase that will have happened over around 10 months would be unprecedented in recent years.

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The rationale for further increases on this scale is questionable, particularly at a time of slowing growth. While euro zone annual inflation remained at a high 9.2 per cent in December, the month-on-month figures fell 0.1 per cent in November and 0.4 per cent in December. This was due in part to government energy supports across Europe to households, but is still a significant turn in the trend that had seen monthly increases over 1 per cent in a few previous months.

The ECB argues that core inflation – excluding volatile energy and food prices – remains stubbornly high and worries about a knock-on to wage growth. But euro zone growth is already weak and battering it down further with rapid interest rate increases could take a heavy toll. There is surely a case for the ECB to heed its own advice from last year and, instead of aiming towards half-point rises at the next three meetings, take it one meeting at a time and see what the data says. For now the council seem determined to take the Mastermind approach to rate increases – they have started so they will finish.

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If the ECB delivers on a deposit rate of 3.5 per cent by summer, that will bring the refinancing rate from which Irish tracker mortgages are priced to 4 per cent. This will be a shock to tracker holders, though most of these are already a good few years into their mortgage. And the huge switching activity in recent months shows that many on variable rates who had the option to do so have now fixed. The greater damage will probably come through a gradual squeeze on new borrowers as new fixed-rate loans are increased in price – and on more recent borrowers coming off shorter-term fixed rates in the coming years. Many of the 100,000 borrowers with credit servicing firms and nonbank lenders will also be more exposed, as they are feeling the full brunt of variable rate hikes.

A full passing on of a four-point hike could increase the cost of a new mortgage by €500 or €600 a month, depending on amount and term. That is more than enough to cool the borrowing market and have an impact on house prices, even if it takes time for the full impact to feed through.

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Higher interest rates – a change in that fundamental factor, the price of money – will reverberate across the economy, changing investment patterns and challenging the viability of projects of all shapes and sizes. Investors in financial and physical assets have been driven for years by the era of cheap money, which created a wall of cash driving money into everything from shares and bonds to Irish housing projects and making it much easier for governments to make ends meet.

For central banks this era continued much longer than they would have liked. They do not see their role as providing long-term support to consumer demand and government borrowing. Rates at zero gave them nowhere to go if economic growth slowed. They now seem determined to grab the chance to end the free money era once and for all. But at what cost?