Storm clouds gather over housing market
This awful housing market background is now costing lots of jobs and economic activity in general, and tax revenues are under serious pressure. Against this background the last thing in the world the Irish market needs is an interest rate increase, but such an eventuality now seems highly likely.
Last Thursday ECB president, Jean Claude Trichet, sent a strong signal he might be tempted to increase interest rates at the July ECB meeting. In a world where the sub-prime crisis is still having a detrimental effect on economic activity, particularly in the US and Britain, such a suggestion seems ludicrous. Indeed, the Americans are not happy about the impact such a move might have on the already extremely weak dollar and are probably also feeling a bit aggrieved that the ECB might not be playing its part in sorting out the sub-prime mess.
From the ECB’s viewpoint, the fact is that inflation is up at 3.6%, well above the ECB’s mandated target of zero to 2%. Furthermore, the eurozone economic background is still pretty robust and is showing few signs of going the way of the US economy. Food and energy costs are the two main factors driving inflation up in the eurozone and, as such, are not indicative of demand-led inflationary pressures.
So if strong demand were not driving inflation up, then increasing interest rates would have little impact. In other words, higher interest rates would do nothing to dampen food and energy costs, which are determined by many global factors.
So why then would the ECB consider tightening rates? It would increase rates purely to try and dampen inflationary expectations. In other words by increasing rates, the ECB would be sending a signal to trade unions and workers that it does not want an inflationary psychology to take hold. I am not convinced by the logic of the argument, but that is the way the ECB appears to view the world.
In the world of central banking there is a lot of double speak, and it is never easy to figure out why many of them do what they do — particularly the ECB. If rates were increased in July, it would in my view represent a mistake but could be reversed fairly quickly.
From the perspective of the Irish mortgage holder and the Irish housing market, what the ECB does or does not do in July is of academic interest because borrowing costs look set to rise regardless over coming weeks. Three-month inter bank interest rates edged over 5% this week — a full 1% above the ECB’s official base rate. This rate is more influential in determining borrowing costs than the ECB’s official rate, as banks fund at inter bank rates.
The unprecedented gap between the ECB’s base rate and the inter bank rate, reflects the ongoing turmoil in global financial markets and this looks set to persist.
If it does, then banks will likely move again over coming weeks to pass on higher borrowing costs to whoever they can. In the mortgage market this means that existing variable rate borrowers and new customers (if such a thing now exists) could be facing higher borrowing costs. It would take an official rate rise to impact tracker mortgages.
For the Irish housing market, such an increase in mortgage rates is the last thing wanted and would exacerbate the already serious pressures. The housing market is still quite a distance from recovery and can certainly get worse before it gets better.
Jim Power
Chief economist
Friends First
