A New Interest Rate Environment - Mazars - Ireland

The ECB decision to raise its lending rates to commercial banks was inevitable.

It was essential from its own point of view (including its statutory duties), however frustrating from any, and even damaging from other perspectives. It is not the last such hike: there will be more … and more until euro-zone inflation is back below 2 per cent. The ECB is back in its comfort zone, targeting inflation now well above the 2 per cent target and in its view dangerously above 3 per cent in some countries, rising everywhere and only in Ireland comfortably below 2 per cent. The Irish standout is not good news really – simply a symptom of the severity and depth of the country’s balance sheet recession. Figure 1 below captures the progress of inflation in the past year.

Fig. 1

Euro-zone inflation, February 2010 and 2011

Source: Eurostat

Now take a long view of euro-zone inflation and official interest rates – the monthly monetary union index of consumer prices (MUICP) and the ECB’s interest rate on its main refinancing operations or rate at which it lends to commercial banks (MRO).

Fig. 2

ECB Interest rate (MRO) and inflation (MUICP) 2001 – 2011

Source: ECB/Eurostat

And now have a close-up look at inflation and selected interest rates in 2000 and 2001 (Fig. 3). Then, inflation oscillated between 2 And 3 per cent and stubbornly refused to settle within target (below 2 per cent). The ECB aggressively pushed its MRO well north of 4 per cent and commercial rates ranged above 7 (business, short-term) and 10 (household short-term). That picture persisted into 2003. As the figures show the ECB has struggled to achieve its grail, to keep euro-zone inflation stable and below 2 per cent.

Fig. 3

Inflation and selected interest rates, euro-zone 2000 – 2001

Source: ECB/Eurostat

The message? In the face of as it sees it, rampant inflation, the ECB will push its official rate to whatever level it takes – even to the range of 4 – 5 per cent – to crush euro-zone inflation down to under 2 per cent – and keep it there. That, in current circumstances, could mean some customer rates sitting at around 7 per cent and north (short-term business lending) and pushing north of 9 and 10 per cent (household short-term) going into or during 2013 depending on where and when price inflation peaks.

The ECB view is simple: inflation is everywhere and always waiting to happen if money supply is not controlled. On this view unless kept in check banks will lend and consumers borrow profligately. Money supply will grow dangerously, stoking inflationary fires with first, prices rising and then a paycheque catch up race creating a wage/price spiral. Any consequences that might arise from using the interest rate to fight inflation (such as higher unemployment, economic slow-down and so on) do not arise from monetary policy and are not for the ECB to tackle. It is for others (governments) to ensure that real economy conditions (wage formation, productivity growth, labour market flexibility, adoption of technical progress and maintaining competitiveness broadly defined) are consistent with central banks keeping inflation in check. This is the world of the non-accelerating inflation rate of unemployment (NAIRU).

Where might fit the NAIRU mould? Germany comes closest – at least in its real economy. Portugal does not – in any sense. Its collapse was inevitable and while its prospects were grim before the ECB hike the situation now – with the bail-out and austerity packages to be agreed – will be awful. Apart from the effects of intensive tourism development along the Algarve coast and some wealth and industry around Lisbon Portugal is underdeveloped and in consequence impoverished. As with any such region it has a poorly developed education system, widespread low levels of educational attainment, a dysfunctional labour market, very high unemployment and even higher and persistent youth unemployment, and high dependence on agriculture with that sector characterised by an ageing population engaged in marginal farming. The list is far from comprehensive but the key point remains, Portugal faces the most mould-shattering adjustments to its economic-, social- and political-institutional fabric in implementing the terms of its bail-out in what will also be a high interest rate regime, certainly near-term.

Ireland should take no comfort from Portugal’s predicament. Ireland also might at this point put aside obsessing about the morale-sapping and asset-destroying effects of its melt-down. The IMF/EU/ECB (‘troika’) bail-out may be compared to a company crashing but succeeding in having itself refinanced (on terms of course). The Irish sovereign is funded for the next couple of years. With a return to growth (this time sustainable) it can gear down debt over the medium term. Companies and households can also rebuild their balance sheets. However as much as for Portugal, for the entire EU it will also be a high interest rate regime as the ECB bears down on inflation, banks rebuild their capital and must meet tougher regulatory ratios.

In this context, certain issues remain within the control of national government and therefore of critical importance. First, the creation of an environment that is actively conducive to real job growth - and this to include both high-tech, high-spec "smart" jobs and employment in more traditional sectors of the economy. And, in the high interest rate environment just commencing, the provision of an alternate funding source for business in Ireland, in essence the strategic investment bank. Both have been heralded in the Programme for Government and need action in the short term.

If you have any questions please contact Mark Kennedy.