ECB may not raise rates as quickly as expected according to Bank of Ireland

– Market had discounted prolonged series of rate increases
– Much less aggressive schedule now expected

In April the ECB raised the repo rate from 1% to 1.25% in a well flagged move, and the market responded by anticipating a series of further increases. This view was based on the ECB’s actions over two previous tightening cycles, when they tended to raise interest rates every three months, with an occasional two-month interval thrown in. On that basis the market in mid-April was expecting a repo rate of 2.5% by mid-2012 and 3% a year beyond that, implying a steady rise in mortgage costs for Irish borrowers on ‘tracker’ mortgages, although we felt at that time that the market was pricing in too much, according to Dr Dan McLaughlin, Group Chief Economist, Bank of Ireland and author of the Bulletin.

“The market has had second thoughts of late, however, with a much less aggressive ECB rate path now projected; the repo rate is still expected to rise over the next few months to 1.5% but beyond that a rate of 1.75% is now expected by early next year and 2% by end-2012. Nothing is certain, of course, (the ECB ‘never pre-commits’) but a number of factors have emerged which may mean that this tightening cycle does not pan out like the last one.

“Economic growth in the euro area has been a reasonably strong 2.5% over the past year and inflation, at 2.7%, is well above the ECB’s 2% target, a combination which has prompted the Bank to view the risks to inflation as being on the upside. Yet the ECB also concedes that there is no evidence that the recent, largely commodity related, increase in prices is either affecting other prices or pushing up inflation expectations. Moreover, the threat of higher rates has helped to boost the euro, which despite a recent fall and persistent concerns about European sovereign debt sustainability is still stronger than it was a year ago. The level of euro GDP is also still some 2% below its peak in late 2007, and the recovery is very uneven across the zone, with Germany well above its long-term trend against modest growth and even contraction elsewhere.

“Other markets, including the US and the UK, had seen a marked change in rate expectations earlier in the year, and the recent trend in euro interest rates partly reflects a response to these developments. The ECB’s rhetoric itself has also been more balanced, with language implying that rates will rise if necessary but not signalling an aggressive move. The near-term path of oil prices and headline inflation could well prove the decisive factor with any upside surprises prompting tightening but any downside surprises leading to a more elongated tightening cycle than seen in 2005-07, when rates moved from 2% to 4% in eighteen months“, concluded Dr. Dan McLaughlin.


For Reference:

Dr. Dan McLaughlin
Group Chief Economist
Bank of Ireland Global Markets
Tel: 01 609 3221

Anne Mathews
Media Relations Manager
Group Communications
Bank of Ireland
Tel: 076 623 4771 / 087 246 0358

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