ECB and Irish Interest 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, 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 third 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 recent change.

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 (16 March 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 3.5%, taking the Deposit rate to 3.0% at the March meeting , believing that inflation is more entrenched and will fall at a slower pace than initially envisaged, although they now forecast it will fall back to the 2% target by the second half of 2025.

The March meeting was also significant as it was set against a backdrop of market turbulence, with bank shares across the developed world coming under heavy selling pressure following the collapse of two regional US banks amid concern about heavy losses on bond holdings, bought at much higher prices when rates were lower or even negative.This uncertainty prompted a change in tone from the ECB, with the rate outlook now seen as data dependent while dropping a previous commitment to ‘keep raising rates significantly’.

Market expectations on future interest rates have changed as a result of the banking sector issues and the ECB’s rhetoric, with another quarter point seen as the last in this rate cycle, although that can of course change as events unfold.