Scottish bank shakes a few houses

The arrival of the Bank of Scotland on the mortgage scene in Ireland has already created more than just a few ripples. The announcement by the State's largest mortgage provider - the Irish Permanent - of a cut of 0.5 per cent on its core variable rate indicates just how seriously the domestic mortgage players take this new competitive force.

In coming weeks, further rate reductions on mortgage products are virtually assured from the leading providers of mortgage finance.

All of this is clearly good for consumers but it does signal that the profit margins on mortgage business are in the process of shifting downwards on a permanent basis. This is clearly negative for the quoted financial companies, particularly the former building societies. For the associated banks the impact on their profits will be marginal given the diversity of their earnings streams.

The current round of reductions in mortgage rates will probably give another fillip to the booming housing market. However, the structure of interest rates in the wholesale money market has not changed and it is trends in wholesale money rates that will determine the future direction of Irish interest rates.

The table shows the key three-month money rates and the 10-year bond yields for the euro, sterling, and the US dollar. The disparity in short-term interest rates is striking with euro interest rates currently just half of those in the US. These higher US interest rates can be virtually entirely explained by the relative performance of the US economy in recent years, which has grown at a far faster pace than the European economy.

Several years of strong US economic growth mean that there is now very little spare capacity in the US economy which is reflected in the record low rate of unemployment at 4.2 per cent. In contrast, unemployment across the euro zone is more than 10 per cent, and indicates that there is plenty of unused capacity across the European economy.

The higher interest rate structure in Britain has probably more to do with that economy's poor record on inflation than its recent record on economic growth. However, the growth experience of the British economy has been better than that of continental Europe, and is reflected in a much lower unemployment rate of just more than 6 per cent.

Looking forward, all the signs are pointing to upward pressure on interest rates across the three economic areas. The US economy has defied all predictions of higher inflation in recent years while at the same time maintaining above-trend rates of economic growth. The US Federal Reserve has already raised the Federal Funds rate by 0.5 per cent this year and further rises seem likely.

Sterling interest rates have declined this year but further declines seem increasingly unlikely given growing evidence of accelerating growth in British consumer demand and a strengthening housing market. Indeed, there is already talk among some analysts of the need for the Bank of England to raise interest rates early to prevent any recurrence of a boom in the housing market.

Even the long dormant continental European economy is showing signs of a widespread pick-up in economic activity. For example, recent second-quarter data for France indicates the French economy is growing faster than predicted and should grow by more than 2.5 per cent this year. Already, the European Central Bank has indicated the next move in interest rates is likely to be upward, although most commentators are not expecting any rise until 2000.

Irish mortgage holders should enjoy the current round of rate reductions, as this is likely to be the last in the current cycle.

Investors in the stock market should factor into their long-term investment framework the strong likelihood that interest rates will be rising gradually over the next 12 to 18 months.