Rates cut train nears final stop

IN the aftermath of the resignation of Oskar Lafontaine as German finance minister, there were some expectations that the European Central Bank (ECB) would respond with a quick interest rate cut. These hopes proved unfounded and the ECB left rates unchanged - and in its bulletin for March it ruled out the possibility of rate cuts for the foreseeable future.

Its belief at the moment is that the current level of interest rates is appropriate for Euroland economic conditions - and it came up with all sorts of excuses to justify its stance. It believed that while the risks to inflation were still finely balanced in either direction, it cited as potential threats: recent wage settlements, the depreciation of the euro, strong growth in private sector credit and the danger of looser fiscal policy.

None of these arguments stack up very well, as the reality is that inflation is a word that shouldn't be mentioned at any dinner party.

Two of the largest economies in the Euro zone, Germany and Italy, are currently diverging to varying degrees from the other member countries. These two slowing economies together account for almost 50 per cent of the Euroland economic bloc and will have a major bearing on where interest rates go from here.

Germany is a very interesting case. Its consumer sector is still positive but it is the industrial sector that is leading the downward charge of the economy.

The weakness of that sector is partly attributable to external conditions, but the most important contributors to the weakness are the tax policies of the former finance minister.

With Mr Lafontaine now gone, and with Chancellor Schroder promising to alleviate some of his more damaging measures, there is a good chance that business confidence could rebound. However, it would take a comeback of considerable proportions to generate sufficient growth in Germany to force the ECB to contemplate tightening interest rates.

Before Mr Lafontaine's resignation, I believed there had been a very high probability that the ECB would cut rates by one quarter of a percentage point and a 50/50 chance that a further quarter point cut could be delivered thereafter. Following his resignation, the economic growth outlook for Euroland has definitely improved and so the chance of two rate cuts has diminished. The balance of probability still favours one cut, but based on the evidence available at the moment, a second cut is a lot less likely.

So, for the mortgage holder, the interest rate gravy train is approaching the final station. Based on prospective market interest rates, it now appears likely that at best the variable mortgage rate will probably fall by just another quarter of a percentage point at most, but of course the exact amount will depend on how the competitors in the mortgage market shape up against each other.

In terms of long-term interest rates, the situation is pretty similar. The rates charged on fixed-rate mortgages are primarily determined by the yields on government bonds. Due to the ongoing strong growth in the US economy, investors in bond markets have become quite nervous in recent months and long-term interest rates have increased quite sharply in the US and European rates have moved in sympathy.

It is anybody's guess how much higher they will go over the coming months, but it appears safe to assume that we passed the trough in longer-term rates late last year.

Consequently, based on current and prospective long-term market rates, the potential for falls in fixed-rate mortgages looks very limited.

In conclusion, we are now very close to the point where variable and fixed-rate mortgages bottom out and borrowers should now be deciding how best to exploit the situation to gain maximum advantage.

An important question to ask is where variable rates are likely to go over the next three to five years and of course we can't answer that question with any certainty.

The balance of risk is in a modest upward direction at least, so for some borrowers the fixing option could look attractive. Every individual case is different and everybody's attitude to risk is different, but everybody needs to give careful consideration to this important question in order to maximise financial benefit over the next five years.

Jim Power is chief economist with Bank of Ireland.