Last autumn it looked as if interest rates would start to rise this year, for the first time since the economic crisis. September had been pencilled in by many as the likely time for an announcement from the ECB. This would have fed through into higher repayments for borrowers here.
But since then there has been a dramatic change in expectations on the financial markets. So what are analysts now expecting? What does this changed scenario mean for borrowers? And are we looking at a new era when borrowing costs will stay low for a prolonged period of time?
Changing expectations
The European Central Bank (ECB), using typically convoluted language, indicated last June it would keep interest rates at their current level until "at least through the summer" this year.
This led to expectations interest rates would start to rise in the autumn, perhaps in September, with predictions that the ECB could increase its key refinancing rate from 0 per cent to 0.25 per cent, with the aim of pushing it progressively higher later in 2019 and through 2020.
Slowing growth has changed that picture significantly and most analysts now do not expect any increase this year, with the majority opting for the first quarter of 2020 as the likely first rate rise.
A move to tighter interest rates was part of a wider ECB strategy of phasing out the massive monetary stimulus
A move to tighter interest rates was part of a wider ECB strategy of phasing out the massive monetary stimulus
Some feel it might arrive sooner, in December, but talk of an autumn hike has been scrapped.
A move to tighter interest rates was part of a wider ECB strategy of phasing out the massive monetary stimulus introduced to fight off the threat of deflation during the economic crisis.
The problem is that there are now clear signs of a slowdown in the euro zone economy and core inflation, stripping out energy prices, remains stuck around 1 per cent.
A string of recent data has underlined the point. An index looking at what EU purchasing managers in industry are buying and expect to produce is now pointing to a decline, with particular signs of weakness in Germany.
This relates in part the impact of the emissions scandal on German carmakers, but also to slowing international demand.
There was more evidence this week of a Chinese slowdown and the US economy is also coming off the boil, hitting demand for EU exporters.
There is a sustained loss of momentum in the euro zone economy, according to Simon Barry, chief economist at Ulster Bank.
“At this stage we don’t have sufficient confidence that the economy is on a healthy path,” he says, even with more positive signals from the jobs market, where wages are rising and unemployment has fallen to 7.9 per cent.
An interest rate rise this year is still possible, but no longer likely
What next
The ECB has starred to react. This week ECB president Mario Draghi said "it is a slowdown, which is not headed toward a recession. But it could be longer than expected."
As a result, expectations that the ECB’s key refinancing interest rate would rise in September are being ditched.
“A rise this year is still possible, but no longer likely,” according to Mr Barry. Forward rates on the market do not price in a rate rise now until 2020.
Not only have interest rate expectations changed but so have those for growth.
Earlier ECB expectations of quarterly economic growth in the euro zone of 0.5 per cent on average now look most unlikely to be achieved.
"The economic data has been disappointing over the last four months and the ECB are going to find it tough get rates back to any kind of normal level," according to Ronan Costello, head of euro money markets at Bank of Ireland.
He believes the ECB will move cautiously, first removing the negative deposit rates charged to banks for depositing money, probably by the end of the first quarter of 2020.
“Sometime after that, when the economy is in a healthy enough position, the ECB could then follow up with a very gradual hiking cycle.”
It is a deeply uncomfortable position for the ECB. They will want to return interest rates to more normal levels so that they have some firepower to cut them in response to the next slowdown. Otherwise they will be in a shoot-out with no bullets.
Lesson from the US
The US is well ahead of Europe in term of its economic cycle, with interest rates cut earlier during the crisis and starting to increase more quickly afterwards.
The interest rate cycle there has been seen as a guide to what might happen in Europe.
The Fed has changed its guidance for this year from three further quarter point rises to two
However, a big change in expectations has also now taken place in the US about the future course of interest rates, due to fears of a slowdown in growth.
The US Federal Reserve, the central bank, has already increased interest rates nine times since 2015 and its key rate is now between 2.25 per cent and 2.5 per cent.
But it too has now changed its guidance for this year from three further quarter point rises to two and the markets feel even this is too aggressive.
Forward market interest rates now anticipate no further rise in US rates this year and even a possible cut in 2020.
Fed chair Jay Powell recently signalled the Fed will be patient as it assesses what to do next.
Mr Costello feels the consensus may now be too pessimistic on US growth, with company earnings and growth in good shape.
“The recent rhetoric from Fed officials supports the view that they will now pause for a few months, but with spare capacity very tight in the US, we would not completely rule out further hikes later this year,” he said.
Expectations that US rates would head steadily higher through 2020 to 3 per cent or higher have been ditched.
How high?
We sometimes forget the extraordinary transformation in interest rates in recent decades. Across the industrialised world, economic growth and inflation are now generally much lower than in the 1980s – and of course exiting from crisis has left particular financial scars .
In general, too, the main economies have older populations,with lower percentages of the population working in the productive sector, which also tends to push down the average interest rate.
This is because with a lower percentage of the population in work, the sustainable growth rate is lower meaning inflation – and interest rates – also tend to be a bit below what they would otherwise be. People are also savings a bit more through their working lives to prepare to live longer, and this also slows demand.
There is significant argument among economists about defining what a normal – or natural – level of interest rates would be and disentangling the cyclical factors from structural economic changes. But whatever way you slice it, the world has now changed , even if you allow for varying rates of inflation.
In a speech last year, ECB chief economist Peter Prate pointed out that long-term interest rates in the US were 8.6 percentage points lower now than in the 1980s, while those in Germany were down almost 8 per cent and in France 12 per cent.
Irish long-term rates were 14-16 per cent in the early 1980s versus around 1 per cent now.
Expectations for inflation have transformed the interest rate picture.
Now, post-crisis, there is new uncertainty about how far rates could rise. Is 2.5 per cent – or even 3 per cent – the peak of the US cycle? And how far can ECB rates rise in the next few years?
Forward market interest rates suggest ECB rates staying low for the next few years. Ronan Costello of Bank of Ireland says that the message from the ECB could be that it will try to move rates gradually away from emergency levels, but that the pace of rate increases will be modest, perhaps between 0.25 of a point and 0.5 of a point per annum.
In previous cycles ECB rates peaked at 4.75 per cent in 2000 and 4.25 per cent in 2008.
Now work undertaken by the Fed and the Bank of England suggests “ the new normal” for interest rates could be in the 2 to 3 per cent region – and it will be a long time before ECB rates approach such levels. Most analysts now thing the key ECB rate could by just 0.5 per cent by the end of 2020.
The outlook for borrowers ... and savers
The low interest rate outlook will come as a relief to borrowers facing significant mortgage repayments, including many who have bought recently, or at the peak of the previous cycle in 2006/7.
While the timing of the first increase remains uncertain, the key point is that expectations for how high rates may go over the next few years have eased significantly.
The clearest outlook is for those on tracker mortgages, linked directly to ECB rates, who may well see no change this year and a very modest rise in 2020. This moderate outlook should also offer decent options to those coming off fixed rates over the next couple of years, including many who bought recently .
Other variable mortgage loans also tend to rise and fall with the ECB rate cycle, though they are not directly linked like tracker mortgages. Competition has led to some improvement in the rates on offer to borrowers in the last couple of years, with new variable rate loans down by around 0.3 of a point since 2016 and fixed rates down about half a point.
Yet average new loan rates in Ireland at just over 3 per cent are still well above the euro zone average of 1.79 per cent. So competition may lead to rates edging a bit further lower, particularly for lower risk borrowers.
For savers, it looks like being a case of having to continue to grin and bear it. Irish banks have wide profit margins on their core lending and borrowing books not only because they charge more than the EU average for mortgage, but also because they pay rock-bottom rates to depositors. So pressure will remain on those seeking a return on their money to look to riskier areas, like the stockmarket, various funds of even rental property.
The bottom line
The bottom line is the expectation of what normal interest rates might look like as we emerge from the crisis into a low inflation and sluggish growth period internationally is changing.
The US Fed has suggested rates where they are now – below 2.5 per cent – may represent what is called the natural rate, the one that keeps the economy in balance in normal times.
In future, rates may no go higher than a range of 2 to 3 per cent. And, as things stand, the ECB looks unlikely to get even close to this territory for quite some time.
