The European Central Bank took many by surprise with the introduction of a rate hike of half of one percent in July.
Given that the ECB hadn’t raised rates in over a decade – and accounting for the alarming rate of deterioration in growth prospects for the eurozone economy – speculation had centred on a modest increase of 0.25%.
However, the regulator has apparently set its sights firmly on bringing inflation in the eurozone under control above all else.
“Price pressure is spreading across more and more sectors,” ECB President Christine Lagarde said after announcing last month’s rate increase.
“We expect inflation to remain undesirably high for some time.”
And indeed, it has remained undesirably high. According to the latest figures from the EU statistics agency, Eurostat, prices across the eurozone increased at a record 9.1% in the year to August.
It has added to fears that inflation may be becoming embedded in the economy and there are predictions of worse to come.
Although oil prices have tempered of late, European gas prices have been soaring.
They are now around 10 times higher than their average level over the past decade.
Davy stockbrokers said this week that the rate of inflation in Ireland is likely to reach double digit territory in the coming months.
Economists at US bank Citi forecast that inflation in the UK could top 18% early next year.
That magnitude of inflation – if it comes to pass – would likely be replicated across the eurozone.
It has no doubt been playing into the considerations of members of the Governing Council of the ECB ahead of their upcoming rate setting meeting next Thursday.
Where in the past, the bank would have given some kind of indication as to how they might move – a practice known as ‘forward guidance’ – they have given up on that for now in light of the rapidly changing inflationary environment.
Christine Lagarde said at last month’s meeting that the bank would from now on make its decisions on a “month by month, step by step” basis and it would be “data dependent”.
So, to an extent, we’re in the dark about what the ECB is about to do, but some members appear to have made their minds up about the data already.
Isabel Schnabel, a German economist and member of the ECB Governing Council, said the inflation outlook had not changed since the last rate increase indicating that she favoured another steep hike in rates.
The Dutch Central Bank President Klaas Knot said he was in favour of another 0.5% hike and possibly an increase of 0.75% at next week’s meeting.
Others have said a three-quarter point rise should at least be on the table for discussion.
However, the ECB’s chief economist and former Governor of the Irish Central Bank, Philip Lane, argued this week that ECB should raise rates at a ‘steady pace’ which appeared to indicate that he wouldn’t support a 0.75% increase.
He said he believed it would be better to move in ‘smaller increments’ over the coming months, giving more time to learn about how the economy is progressing.
If the ECB was to opt to raise interest rates by 0.75%, it would mark the first time its borrowing rate would have gone up by such a margin since the euro was created in 1999.
Prior to July, the borrowing rate hadn’t been increased by 0.5% since mid-2000.
It’s an indicator of the magnitude of the inflationary problem facing the ECB’s policymakers at the moment.
It wouldn’t be a leftfield move in the current rate hiking cycle globally, however.
The US Federal Reserve introduced two back-to-back hikes of 0.75% in recent months with a repeat possible this month.
So, a 0.75% hike here is certainly not out of the question.
What would that mean for mortgages?
Apart from tracker mortgage holders – who automatically get the hit from interest rate increases – the main bank lenders held off from increasing rates on their variable and fixed rate products after the ECB announced its July rate hike.
Avant Money, which has among the cheapest rates on the market here, recently announced that it was increasing its rates for a second time this year ranging from a 0.3% increase on its three-year fixed rate – bringing it to 2.25% – to a full percent on its longer-term fixed rates of up to 30 years.
It also increased its variable rates.
ICS Mortgages announced another increase of a whopping 1.25% on its variable rate products last week which followed a decision by the lender to cap the size of new home loans at two and a half times income.
Finance Ireland also raised rates in its fixed rate products in recent months.
While the exact size of any future move from the ECB is unclear, one thing we can say with some certainty is that interest rates are going to rise further in September and lenders will almost certainly pass that on to their variable rate customers and probably on to some of their fixed rate products too.
A full 0.75% increase – if it is delivered and passed on – would add around €100 per month to to average mortgage of €250,000, according to Alison Fearon, Managing Director of Switcheroo Mortgages.
However, she said the biggest shock would likely be reserved for those who are coming to the end of a fixed rate period and on to the lender’s standard variable rate (SVR), which from some lenders is as high as 4.5%.
A full 0.75% increase would see that rate moving over 5%.
“Over the last few years many customers will have taken up short term fixed rates of around 2.25% which will mature over the coming year. When they do, they could face a jump in interest from 2.25% to as high as 5.25%,” Ms Fearon said.
“For the average mortgage customer this would be an increase of €400 per month or almost €5,000 per year,” she calculated.
The logical thing would be to fix again or even switch providers, but some could struggle to demonstrate their ability to afford a mortgage with a new provider against the backdrop of cost-of-living increases and limited pay rises, Alison Fearon points out.
That could see many getting trapped in what she described as an ‘SVR trap’ which she said could be financially devastating for people already struggling.
“Customers facing this predicament could see a total cost of living increase of €8,500 per annum from where they were one year ago,” she said.
She urged those on fixed rates to examine the option of breaking and refixing to give them a longer fixed period.
In some cases, the provider will not charge a break fee. However, it’s imperative to check with them first.
What about trackers?
Most tracker mortgage holders have had it good for many years.
With the ECB base rate languishing at or close to zero since the middle of the last decade, servicing a tracker has been very cheap by historical standards. That’s now changing.
From this month, they will be paying a 0.5% premium on their previous rate.
Joey Sheahan, Head of Credit at MyMortgages.ie and Author of the Mortgage Coach did some sums on it.
Using a borrower with €300,000 outstanding on a mortgage with a tracker rate of 1%, with 20 years remaining on the term, they would have had monthly repayments of €1,379 up to now.
“A 0.5% interest rate rise will increase this to €1,447 – which is an annual increase of €816, or €16,320 over 20 years,” he calculated.
At least another 0.5% can be expected next week bringing that mortgagee’s tracker to 2% – or an increase of a full percent in the space of a few months.
“A 1% rise in the ECB’s benchmark rate would increase the monthly repayments to €1,517, which is an annual increase of €1,656 or €33,120 over 20 years,” Mr Sheahan calculated.
How high could rates go?
At the start of the year, ECB rate watchers were pencilling in a rate hike of 0.25% by the end of the year with the possibility of the deposit rate (then -0.5%) going back to zero.
That was already achieved by July and with speculation centring on a 0.75% hike next month – and with two more rates meetings to come before the end of the year – the deposit rate could well be above 1% by Christmas.
Going by what the more ‘hawkish’ elements of the Governing Council are saying, the deposit rate could be closer to 2% by then with the borrowing rate heading towards 2.5%.
“Europe’s inflation problem is so large at this moment that I think it’s our duty to raise rates every six weeks until the moment that inflation stabilizes,” Dutch Governor Klass Knot told the Dutch national broadcaster NOS last week.
In 2008, inflation rose to 4% and the ECB raised interest rates to 4.25%.
Inflation at 9% – and possibly going higher – makes it difficult to predict where rates might end up.
The more ‘dovish’ elements of the ECB Governing Council, including Philip Lane, are urging constraint.
They advocate taking a step back and looking at the bigger picture.
In the context of recession or economic slowdown, consumer and business demand would fall, acting as a lag in inflation itself.
In that scenario, the ECB should arguably move more slowly. After all, when they hiked rates in 2011, they had to reverse the increase within months.
The outcome of next week’s meeting will be very telling. If the ECB opts for a hike at the higher end of expectations, it would indicate that the hawks are winning the argument about inflation and more steep rate hikes can be expected for the rest of the year and into next year.
The era of cheap money is well and truly over – for the foreseeable future, at least.