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, with the floor for short term rates 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 quarter of outstanding loans are of this type, with an average spread of 1.05%.
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 stood at -0.5% before the onset of the current tightening cycle in July 2022..
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. The ECB introduced an additional bond purchase scheme in 2020, the PEPP, to counter the impact of the pandemic on economic activity and inflation. The July meeting last year also revealed the birth of a new policy tool – the Transmission Protection Instrument (TPI) which will buy bonds where the ECB feels that ‘fragmentation ‘ is occurring and hence compromising its monetary policy across the euro area. Eligibility is conditional on a given country pursuing appropriately sound fiscal policies.
Rate Outlook (30 June 2023)
The ECB lagged both the US Federal Reserve and the Bank of England in tightening monetary policy, with the first rate rise in this cycle not coming to July last year, reflecting their initial view that the spike in inflation was largely energy driven and transitory. They have now raised rates by 4.0%, taking the Deposit rate to 3.5% at the June meeting , believing now that inflation is more entrenched and will fall at a slower pace than initially envisaged, and still forecast to be above target by the second half of 2025.
The rhetoric from the ECB is arguably contradictory, as it is ‘data dependent’ but President Lagarde states that rates have to go higher, with another rise signalled for the July meeting, although this is not deemed forward guidance. Headline inflation is falling steadily, down to 5.5% in June, but the core measure remains sticky, above 5%, which is of increasing concern to the Bank. Credit growth has slowed sharply , as has monetary growth, which has helped push the ECB to raise rates in quarter points rather than 50bp per meeting.
Market pricing implies that traders expect rates to rise to 3.75% with a high probability of reaching 4%, although that is deemed the likely peak.