ECB decision: rate hike will cause further deterioration in the economy this year

INFLATION IN Ireland will increase substantially and the economy will weaken further as a result of the increase in euro zone interest rates announced yesterday by the European Central Bank (ECB).

The ECB yesterday raised its key interest rate from 4 per cent to 4.25 per cent in an effort to contain rising euro zone inflation. As this increase is passed on to Irish borrowers, it will drive up the cost of money in Ireland by one-quarter of a percentage point.

A general rise of this magnitude in mortgage rates alone would add 0.6 percentage points to the annual rate of consumer price inflation, the Central Statistics Office estimated yesterday. Consumer prices rose by 4.7 per cent in the year to May 2008.

The increase in interest rates will be felt most keenly by households with large mortgages. In a typical case, the rise in ECB rates, when passed on to mortgage borrowers, would add some €48 per month to the cost of a standard variable rate mortgage of €300,000 repayable over 30 years.

The increase will cause a further deterioration in the economy’s faltering performance this year. Effectively, it administers a further dose of deflation to an already weakened economy. Already on the cusp of recession, with asset prices falling steeply and the pace of credit growth slowing sharply over the past year, a further tightening of monetary policy is wholly inappropriate to current Irish economic conditions.

The increase will impose higher borrowing costs on business and households while compromising the competitiveness of Irish exports on US and British markets. Higher borrowing costs will squeeze profit margins while deterring businesses from investing in the future. Increased mortgage repayments will leave households with less discretionary income to spend. As a result, domestic demand will weaken further.

The ECB interest rate increase will also blunt the export drive. The euro strengthened against the dollar and sterling yesterday, closing at £0.799 against sterling and $1.589 against the dollar.

However, the ECB’s decision was not framed with Irish economic conditions in mind. Instead, it was dictated by the desire to break inflationary expectations throughout the euro area, thereby obviating a recurrence of the “stagflation” of the 1970s, where very high inflation rates coincided with stagnant growth in Europe.

The policy implications are stark: no compensation in terms of domestic wages or prices for externally-generated inflation caused by increases in global commodity prices.

This approach was amplified yesterday by the ECB president, Mr Jean-Claude Trichet, in justifying the interest rate increase.

“It is imperative to ensure that medium to longer-term expectations remain firmly anchored at levels in line with price stability. The shift in relative prices and the related transfer of income from commodity-importing countries to commodity-exporting countries have to be accepted. They require a change in behaviour of companies and households.

“Therefore, broadly based second-round effects stemming from the impact of higher energy and food prices on price and wage-setting behaviour must be avoided,” Mr Trichet said.

The ECB’s approach was criticised yesterday by Richard Bruton, the Fine Gael deputy leader and finance spokesman. He said the ECB’s strategy could reinforce the economic slowdown.

In operational terms, the ECB’s mandate is to ensure the stable purchasing power of the euro by keeping the rate of inflation in the euro zone below, but close to, 2 per cent. Inflation in the euro zone – excluding mortgage interest – has been creeping steadily upwards this year, due principally to rising food and energy prices.