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                                  Interest rates


 

 The ECB and Irish rates

Interest rates for borrowers and savers as set by banks in Ireland are determined by a range of factors, including competition in the market, the risk appetite of lenders, the risk weighting of specific loans and the cost of funds for the banks, but the floor for short term rates is set by the ECB

Euro area banks are required to hold reserves with the ECB and historically the latter controlled short term interest rates via the rate (refi rate) it charged on its  Main Refinancing Operation , paid by  banks to borrow money for a week. In the past Irish banks offered  mortgages linked to this rate (Tracker mortgages) and a third of outstanding loans are of this type, with an average rate of 1.05% as the  refi rate was cut to zero in March 2016.

In recent years the ECB has been supplying massive amounts of excess liquidity to the banking system and so short term rates are now closely linked to the Deposit Facility, the rate  the ECB will pay  on deposits from the banking system. This was cut to a negative rate in June 2014 and since September 2019 has stood at -0.5%.

The ECB cannot control longer term interest rates but can influence them by means of Forward Guidance ( indicating to the market how long it expects to keep rates where they are) or by buying Government and Corporate bonds (Quantitative Easing) which seeks to impact longer rates in a more direct manner.


 

Rate Outlook (9 November 2021)

The ECB has effectively raised it inflation target (it is now 2% from 'close to but below 2%')and announced at its July meeting that it intends to keep rates at their current level or lower until three conditions are met

1.Inflation reaches 2% 'well ahead of the end of its projection horizon' (which is 2-3 years)
2.Inflation is deemed to remain at the target 'durably' for the rest of the forecast horizon.

3.Underlying inflation is seen to be consistent with  maintaining the 2% target in the medium term.

 

Inflation has accelerated  sharply in recent months, initially due to higher energy prices but more recently to broader drivers, largely on the supply side, to 4.1%  in October, so one might argue that condition (1) above has been met, The ECB believes this inflation upturn to be short-term , however, and core inflation is still around 2%..Consequently the Governing Council still expects inflation to be 'well below' target in the medium term and will maintain its 'persistently accommodative monetary policy stance'.

Inflation in the near term is likely to rise further and the market is now beginning to doubt whether the ECB can keep rates low for as long as previously thought; 5-year rates turned marginally positive for a brief period in late October but have fallen back again into negative territory, albeit substantially higher than the  -0.4% seen in the summer, while market s appear priced for a rate rise in the latter months of 2022.. Market-based measures of inflation expectations have also risen so ECB rhetoric will be scrutinised for hints of  any change in the current stance.