Interest hike will lead to ‘vicious circle’

CONSUMER spending is set to fall this year, hitting exchequer returns and retailers as increases to tax, interest rates and energy costs eat into households’ discretionary spending.

Chief economist at Goodbody Stockbrokers Dermot O’Leary believes the impending increase in interest rates signalled by ECB president Jean-Claude Trichet on Thursday will impact consumers.

“In terms of its impact on consumer spending, we estimate that every 1% increase in interest rates hits disposable incomes by slightly more than 1%, if maintained for a full-year. Giving that disposable incomes will fall on the back of higher taxes, lower employment and falling earnings, this firm’s view is that consumer spending will fall this year.”

He said the rate rise will likely drive up mortgage rates, something to bear in mind given that the results of the Prudential Capital Assessment Review exercise in the banks imminent.

“We have said before that we think a return to stability in the banking system is more important than the effects of interest rate increases (i.e. supply of credit is more important that the cost of supply). We are still of this view but the pressure is now firmly on with a rate hike on the way next month.”

He said it is clear the ECB is no longer comfortable having rates at 1%. “We don’t imagine rate hikes to be rapid ... but it is clear the up-cycle will begin earlier than we would have expected. We are still of the view that two 0.25% rate hikes to 1.5% will occur this year, but the risks to this forecast are tilted to the upside.”

Treasury management expert John Finn of Treasury Solutions said the impact of a rise in rates would be minimal if fixed-rate mortgages at market rates were available. Then borrowers could effectively hedge against increase in interest rates. He believes the increase in rates will have several knock-on effects in the Irish economy.

“Borrowers who can afford to save to protect against rate hikes will do so, decreasing consumer spending. This will result in lower retail sales, lower vat revenues and higher redundancies in this sector, which in turn leads to lower PAYE, higher welfare, etc. All of this will increase the government deficit ... and will reduce our ability to repay sovereign debts.”

He said there would be further mortgage arrears.

“If there are significant mortgage arrears when the base rate is at 1%, what will the level be like at a base rate of 3% to 4%?

Mr Finn said higher arrears lead to higher bad debt provisions at banks, higher losses/lower profits and higher capital requirements for banks, which can only borrow from the government, which can only borrow from ECB/IMF.

“The government will struggle to pay existing debts so you have a vicious circle. The economy is cannibalising itself,” he said.

Picture: ECB President Jean-Claude Trichet

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