The free money party is over. This week the penny has really started to drop. US interest rates rose, stock markets took fright, Government borrowing costs marched ever higher and the odds on an ECB interest rates increase in July increased significantly.
Everyone knew the era of super-low interest rates and central banks pumping money into economies would end some day. Now “some day” has come. Nobody thought this would take place against the backdrop of a pandemic, a war and soaring inflation. But here we are.
This was a landmark week. Any argument that interest rates are not set for significant increases this year has been swept away. The Federal Reserve, the US central bank, not only increased interest rates by half a percentage point but also signalled two more half point increases were likely at the next two meetings. The Bank of England pushed up UK rates and forecast a recession late this year.
And in Europe there are now clear indications that those who wanted to proceed cautiously and hold off interest rates increases until later in the year have lost the argument. The odds on a July increase in one of the ECB rates has increased significantly. Further rises will follow over the autumn.
The ECB will start with its deposit rate, now minus 0.5 per cent, which is likely to rise in a few steps back into positive territory over the second half of the year. This is not the ECB rate which affects tracker mortgages – though that rate too may now start to increase later this year and into 2023. Either way, the trend in interest rates is now firmly upwards and this will start to be reflected in new borrowing offers and variable rates in the months ahead.
The big hit to people's pockets will affect spending. And that insidious factor – uncertainty – is starting to affect business and consumer sentiment
Borrowing rates remain low by historical standards – and way below inflation. But they are now heading steadily higher. And a key point here is uncertainty. We have no idea how the war in Ukraine will play out – bar fearing it will drag on – and the impact on energy prices and thus inflation and interest rates are all impossible to forecast.
Markets – and central banks – are betting that inflation will ease a bit as the year goes on and that rapid inflation is not yet entrenched in people’s expectations. But the fight to get inflation down could be more difficult than expected and require significantly higher interest rates – Deutsche Bank predicts US base rates could go to 5-6 per cent. Let’s hope they are wrong.
In Europe the picture is hugely complicated by the war, which is simultaneously pushing up prices and slowing growth. The ECB is facing flak for missing the boat as the Fed and the Bank of England push interest rates higher. But it will also get criticised if it raises rates in the teeth of a recession. There may simply be no right answer here – no sweet spot which holds down inflation and doesn’t hit growth.
The backdrop to this is that for years central banks have been pumping cash into economies to try to drive up inflation. This held down interest rates and left investors scrambling to find assets which could yield a return – any return. And so we have seen a big jump in stockmarkets, a massive surge in bond markets and all kinds of property prices rising. And international investors scouring Ireland for any kind of opportunity.
We won’t see all asset prices falling now. But a lot of them will. Technology stocks, bought on the hope of profits tomorrow, are suffering. If investors can get a 3 per cent return by buying a US government treasury, then the whole world of investment changes.The benchmark for every investment worldwide has just shifted.
For the Irish economy there are important messages. Growth here has been very strong and unemployment has fallen back to pre-pandemic levels. The economy has momentum. But increasingly there are fears of the impact of the war and higher interest rates on international growth.The big hit to people’s pockets will affect spending. And that insidious factor – uncertainty – is starting to affect business and consumer sentiment.
Meanwhile, the cost to the State of borrowing is marching higher. From closer to 0 per cent at the start of the year, the 10-year borrowing rate is now 1.75 per cent. There is a good chance it will be 2.5 per cent to 3 per cent before the year is out – maybe sooner. This isn’t catastrophic, but it will add to the squeeze on the budget sums. And we don’t know what lies ahead over the next few years.
For Ireland it is a time to keep the head down and meet the budget targets. Any surprise deterioration in the budget numbers will be punished
Ireland’s fiscal position is strong but it will be vital to keep it that way. A big test is coming. While all the focus is on ECB interest rates, the central bank is also going to wind down its massive programme of purchases of Government bonds over the summer. For the last couple of years, anyone buying Irish borrowings – or those of any other euro zone state – knew they could flog it on to the ECB if needed.
This backstop is being removed. Already there is nervousness about Italian borrowings. For Ireland it is a time to keep the head down and meet the budget targets. Any surprise deterioration in the budget numbers, or sign that Ireland is moving off course, will be punished.
The money has not been really free, of course, in recent years. At some stage borrowings have to be either repaid, or in the case of State borrowings refinanced. But borrowing at zero interest rates has given a huge boost to the Irish exchequer. Now this era is done. Irish politics faces a big job in adapting to new reality.