Economics: The likely ceiling for ECB rate increases over the next few years may well be 3.5 per cent or below, writes Dan McLaughlin.
Household debt in the Republic amounts to 113 per cent of disposable income, according to the Central Bank, having doubled in the past seven years. This makes the economy more vulnerable to any increase in interest rates, particularly the housing market, as 80 per cent of the debt is secured on property, with most of the borrowing at a variable interest rate.
The cost of money in the Republic is also unusually low, as the European Central Bank (ECB) has kept the repo rate at 2 per cent since June 2003, despite a trend towards higher rates elsewhere.
In the US, for example, last week's quarter point increase by the Federal Reserve was the sixth successive rise, taking short-term interest rates there to 2.5 per cent, from 1 per cent eight months ago. Others have followed the Fed's lead in the past, so Irish borrowers might reasonably expect an upward move in interest rates at some stage in 2005.
The timing and magnitude of any future monetary tightening by the ECB is more difficult to predict than the actions of the Fed, as the latter is more transparent and has, for some time, clearly articulated its intentions.
The Fed believes that the US economy is now expanding at an acceptable rate (4.4 per cent GDP growth was recorded in 2004) and so the need for unusually low interest rates has gone. The goal is to move rates back up to a "neutral" or normal level, although as inflation is not seen as a threat, this can be accomplished at a "measured" pace. The latter term has been taken by the market to mean a quarter-point increase per meeting (they occur at six week intervals) and, to date, this has been the case.
The only uncertainty remaining surrounds what constitutes the "neutral" rate target - we know that rates are going to rise further, but the final resting place is open to debate because the Fed refuses to be tied down to a specific numeral value for "neutral". There are some clues available, however, not least historical experience, which points to around 4 per cent, as this is the average Fed funds rate over the past decade. Some argue that the low inflation environment makes this too high a target, preferring a figure nearer 3.5 per cent, and the 3.5-4 per cent range appears to be the target envisaged by most market observers.
The ECB has been reluctant to spell out as clearly its intention to move rates up to a "neutral" level but it does concede that euro interest rates are unusually low and the ECB is concerned about some of the consequences, including a rapid increase in mortgage lending in some member states.
The ECB president went further last week, warning about "unsustainable price increases in property markets" in some parts of the euro area. In fact, the low level of interest rates and the resultant monetary expansion is deemed a risk to price stability and, as such, a possible justification for a rate rise.
The problem for the ECB, however, is that the euro area's economic performance has been limp despite low interest rates; the euro area probably grew by around 1.8 per cent in 2004, the third consecutive year of expansion at a pace below its potential (albeit probably now as low as 2 per cent), even though the global economy had its best year since 1973.
So the growth of mortgage lending and house prices may be a sufficient condition to raise rates, but a pick up in economic growth is probably a necessary condition, as the ECB would find it difficult to justify tightening monetary policy in an environment in which growth has struggled to exceed 2 per cent.
Economic activity in the larger European economies was particularly weak in the third quarter of last year but the most recent data point to an acceleration in the fourth quarter and to a stronger start to 2005.
Nevertheless, the ECB may require a solid first-quarter GDP figure before it contemplates raising rates, and this will not be clear for some months yet - it could be May or June before there is a real chance of a rise in Irish mortgage rates.
The magnitude and pace of any monetary tightening is also likely to be modest. Inflation appears well behaved and wage growth is muted so there is no need for the ECB to rise rates at a fast clip.
The concept of a "neutral" rate is also useful in determining where rates may eventually peak once they start moving higher, although again the ECB is less than forthcoming on this. A simple average of the ECB's repo rate since its inception gives as good a guide as any, pointing to a 3 per cent target. Some would argue this is too low and 3.5 per cent is a better approximation, but the general conclusion should be reasonably reassuring for those holding Irish debt - rates may indeed rise this year, but the likely ceiling over the next few years may well be 3.5 per cent or below in the absence of an inflationary shock.
Dr Dan McLaughlin is chief economist at Bank of Ireland.
