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. Both have now ceased buying in net terms but will reinvest the proceeds of maturing bonds to maintain the gross figure.

Rate Outlook (25 July 2022)

Inflation has accelerated  sharply in recent months, initially due to higher energy prices but more recently to broader drivers, largely on the supply side, consistently exceeding ECB expectations, and this prompted a significant change in ECB rhetoric and now policy. The PEPP has now ended and net asset purchase ceased at end-June, with a quarter point increase in rates pre-announced for the July meeting. Another was to follow in September, although that could be half a point, with further tightening signalled. In the event the 21 July meeting announced a half point increase in rates, with any further increases now data dependent. Consequently the refi rate has risen to 0.5% with the deposit facility rate at zero so marking the end of negative rates.

The July meeting 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.

Although longer dated money market rates have already risen sharply, retail mortgage rates did not rise significantly in Ireland,perhaps due to the large scale of excess deposits in the main Irish banks. That will change though and Tracker rates will begin to increase in line with the ECB’s refinancing rate, the first increase since 2011.The market is also weighing the risk of recession, which has prompted rate expectations to be pared back ; five year market rates were 2.25% in mid-June, from zero in early February , but have fallen to around 1.5% on signs the German economy is contracting.