ANALYSIS:The timing of an upward move in rates is crucial for the Irish economy, writes DAN O'BRIEN
FOURTEEN MONTHS ago, at its May 2009 meeting, the European Central Bank (ECB) cut its key official interest rate by a quarter of a percentage point to a record low of 1 per cent. As expected, it left that rate (and others) unchanged yesterday. But this period of historically cheap money will not last forever.
The timing of an upward move in rates, though not expected by ECB watchers until well into next year, could hardly be more important for the Irish economy.
With rapidly rising public debt levels, anything that adds to recent upward pressure on debt servicing costs could bring the country to a tipping point. And the debt levels of Ireland’s corporate sector are already high by euro area standards.
The household sector is as exposed to rate increases as any other sector in the 16-member bloc, with high levels of debt and a high proportion of mortgages on variable rates. Any increase in rates would slow the rebuilding of balance sheets and suck discretionary income from the economy, dampening consumer spending.
“High uncertainty” is the phrase used twice by the ECB’s president, Jean Claude Trichet, at a press conference yesterday to describe the outlook for just about everything. Given that central bankers tend towards understatement, this puts it mildly. But it is clear from the bank’s thinking on future inflation – the central determinant in its decision-making process – that the probability of a rate rise this year is close to zero.
While Trichet did talk of “upside” risks to the bank’s near-term inflation projections, this was merely dutiful (among central bankers, he who fails to see inflation risks is considered a charlatan). Among the risks he checklisted was the possibility of commodity prices taking off as they did up to mid-2008. Another issue flagged was the likelihood of higher government-controlled prices as countries introduce new taxes and charges as part of their deficit-cutting measures.
The “downside” risks to the bank’s inflation forecast (ie the risk that inflation will turn to deflation) are clearly given greater weight, even if Trichet continues to talk of the upside and downside risks being balanced.
His insistence that inhabitants of the euro area do not anticipate higher inflation would appear crucial (central bankers place great weight on expectations of future inflation, which they believe to be self-fulfilling).
In addition, the risks of the recovery faltering, something that would sap aggregate demand and push prices down, are of a higher probability and potential impact than all the upside risks combined. Trichet spoke of concerns about “renewed tensions in financial markets” and the possibility of “negative feedback loops” between the real economy and the financial system.
The earliest conceivable increase in interest rates will not come before the new year. That should give households, businesses and government some breathing space, and a chance for the recovery to gain a firmer foothold.
