The unexpectedly sharp increases in interest rates over the past year have had many disparate consequences. The increases are the result of the response of the European Central Bank (ECB) and other central banks to the surge in inflation. Central banks hope that, by increasing the interest rates they pay on the deposits made with them by banks, they will slow spending in the economy, thereby reducing the upward pressure on prices.
It’s the main tool they have, but it’s a blunt one, and experience shows that it acts on inflation with a considerable, unpredictable delay. That is why there has been so much uncertainty about how much more central banks will increase their interest rates, and for how long they will stay high.
Policymakers have been warning that further increases are on the cards, but, since the bank failures in the US and Switzerland last month, financial market participants have lowered their expectations of where interest rates will peak. Market prices now imply that there is only another one half of a percentage point further to go in the euro area, to be followed by some reduction next year. Market prices suggest that US interest rates have already peaked.
Rising interest rates were what felled Silicon Valley Bank, the biggest of the American banks to collapse. It is not just the fear of further banking instability that is holding back further rate increases, but the belief that greater caution on the part of banks might reduce spending further. Indeed, most forecasts imply that inflation will slow considerably this year and next in the euro area, the US and Britain, though prices will still be rising much faster than targeted.
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It’s not clear why banks have been so slow to raise rates. Perhaps they don’t want to experience again the kind of reaction their branch closure announcements triggered last year
And then what? Are the years of super-low interest rates at an end, or can we expect to see a return to cheap money when inflation is vanquished? This week the IMF published the results of its recent research into this question. Its conclusion is that the forces that gave us low interest rates, including demographic changes and a slowdown in productivity growth, are likely to reassert themselves and bring back low interest rates in the medium term. Unless, that is, government borrowing becomes more entrenched in the major countries.
[ ECB’s Nagel says further to go on interest-rate hikesOpens in new window ]
The ECB rate increases have been passed on fully to those Irish mortgage borrowers who still have a tracker rate. But other borrowers have benefited from the fact that bank interest rates have not moved up fully in line with the ECB rate. It’s not clear why banks have been so slow to move. Perhaps they don’t want to experience again the kind of public and political reaction their branch closure announcements triggered last year. But this phenomenon of slow adjustment of retail interest rates has also been seen in many other euro area countries.
[ Irish inflation will ease to average of 5% this year, Central Bank expectsOpens in new window ]
Interest rates to depositors have also increased by only small amounts, and the same is true of the various State Savings schemes: the recently announced increase in offered returns is far lower than the increase in rates the Government has to pay for its wholesale borrowings.
Lender discretion
One category of Irish mortgage borrowers seems to have lost out, though, namely those whose loans were acquired by some of the funds who came in when the banks needed to shrink their portfolio after the financial crisis. These borrowers do have the same legal and regulatory protections as bank borrowers, but that protection doesn’t extend to controlling interest rates.
As with most other European countries, Ireland has largely relied on competition to keep the mortgage “standard variable rates” in line with commercial realities. The standard variable rate was never a very satisfactory contract, though, given the amount of discretion it left with the lender. Several years ago, the Central Bank of Ireland began to insist that banks be a lot more transparent about their method of adjusting interest rates. But at what point does exercise of such discretion by lenders on the rates they charge amount to an abuse?
Property developers are complaining that the cost of development funds is becoming prohibitive and delaying the construction of much-needed housing
It is likely that these funds have experienced a bigger increase in their own interest costs than have the banks. But that would not have given them any leeway to raise rates higher than their competitors – if they had any competitors. The problem is not just that bank competition is increasingly limited, with the exit of Ulster Bank and KBC. Funds that are not actively seeking new borrowers are unaffected by competitive concerns. They are simply focused on maximising the return on the portfolio of loans they have already bought. Some of the borrowers whose loans are now owned by such funds may be able to find an alternative cheaper provider, but many have poor credit records and will not be able to move. This is a trap that deserves close regulatory attention.
Meanwhile, property developers are complaining that the cost of development funds is becoming prohibitive and delaying the construction of much-needed housing. They point to the still relatively low cost of funds to the Exchequer and would like to benefit from this being passed on to them. They are right only in regard to the desirability of the Government bringing more of its financial resources to bear on housing construction. But this should be done by the State (and its agencies) acting as an entrepreneur, securing the benefits for the general public, and not by way of subsidised finance to private developers.
Patrick Honohan was governor of the Central Bank of Ireland from 2009 to 2015.