Irish bonus as European Central Bank set to keep rates low for longer

Washing over the EU is a flurry of supportive economic figures; from robust unemployment data to solid GDP data.

The eurozone looks to be emerging nicely from years of dampened growth. However, one figure is gnawing at European Central Bank (ECB) members: inflation.

Figures released last week showed headline inflation across the single currency area has dropped from 1.9% in April to 1.4% in the year to May. The ECB’s target is just below 2%; thus the ECB will largely ignore headline inflation as it is skewed by fluctuations in energy prices, food, alcohol, and tobacco.

Instead, policymakers will focus on core inflation which has remained mostly unchanged at 0.9%, half the ECB’s target mark. Since core inflation remains so subdued, the ECB has continued to purchase assets.

Unemployment is at its lowest point since 2009. From March to April, the jobless rate fell to 9.4%, a reflection of the growth we’re seeing in the eurozone. However, this growth is not translating into wage growth.

Germany is a perfect illustration of this; as Europe’s most robust economy, jobless reports show record-lows of 5.7%. Despite being tantalisingly close to full employment, inflation in Germany remains subdued and wage growth is somewhat stagnant. Having Europe’s strongest economy experience lagging inflation while veering near full employment does not instil much confidence for future interest rate increases. Even in some of Europe’s weaker economies unemployment is pushing down.

So, why have wages remained subdued if unemployment is decreasing? This is an ongoing conundrum for the ECB in that the 9.4% unemployment rate is not low enough to enact wage growth. One explanation is that labour market ‘slack’, or those not actively seeking employment, has continued to be quite high as the economy has begun to improve. Many of the jobs created post-economic crisis have been part-time or short-term, thus headline unemployment data may be skewed.

Markets predict that the ECB will probably not start to raise rates until January 2020. But this may even be too late for a change in policy. As Mario Draghi, president of the ECB, stated in September, the need for higher wages in the eurozone is “unquestionable”. If wages continue to lag it will be difficult for the ECB to reach its target mark of just below 2% inflation.

Longer-term forecasts show that inflation will only tip up gradually. In 2018, inflation will have advanced to about 1.3%. By 2021 it is estimated that inflation will need to be around 1.8% and at this point the ECB can start to increase the cost of borrowing without causing panic and negative growth figures in the region. Moreover, the eurozone has continually undershot the ECB target and, therefore, a reasonable expectation for higher interest rates would be 2021.

For those wishing to save, this is bad news. Accumulating wealth in a bank in a low yielding is a lowly option. Pension funds and insurance companies are also at risk if low interest rates persist.

Poor profitability continues to ail Irish and European banks, eroding potential profit and keeping market capitalisation down. Thus, banks are unable to harbour the perils of non-performing loans. This kind of loose monetary policy leaves the ECB in a very fragile position with little room to manoeuvre if another financial crisis were to take place.

However, for borrowers paying off mortgages, subordinately low interest rates will be accommodative for years to come. By reducing the incentive to save, low interest rates provide a stimulus to the economy. Conversely, when interest rates rise there is a vacuum effect, by which money is taken out of circulation and funnelled into saving accounts. The ECB will gather this Thursday to deliberate on future interest rates.

  • Adrienne Murphy is chief market analyst with Dublin-based online foreign exchange and contract for difference broker AvaTrade

Adrienne Murphy


Lifestyle

We hear a lot about the geese, ducks and swans that arrive here from colder climes for the winter, but much less about smaller birds that come here to escape harsher conditions in northern Europe.Keep an eye out for redwings this winter

More From The Irish Examiner