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 1.1%.
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 (7 February 2025)
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 2022, reflecting their initial view that the spike in inflation was largely energy driven and transitory. They subsequently raised by 4.5%, taking the Deposit rate to 4.0% and the refi rate to 4.5%.
The ECB is now leading the rate cut cycle , staring with a quarter point reduction in its key rates at the meeting on 6th June last year, followed by a further series of 25bp cuts in the deposit rate , the most recent being at its January meeting, taking it to 2.75%. Tracker rate holders in Ireland received an additional benefit as the refi rate has fallen by 160bp, to 2.9%; the ECB believes that its policy of reducing excess liquidity will mean the deposit rate will become less material in driving market rates and the refi rate more significant, prompting them to reduce the spread between them to 15bp from the previous 50bp.
The ECB staff forecasts project inflation falling to the 2% target in 2025 and the Bank is also showing concern about the risks to economic growth, so the Governing Council are generally signalling that rates can fall further.However, services inflation remains high (at around 4%) and the ECB rhetoric remains that they are data dependent and not pre-committed to a rate cutting timetable. Market expectations are volatile and currently signalling three further quarter point cuts this year, taking the Deposit rate to 2%.