As inflation soars, there’s been much discussion around the prospect of a rise in interest rates. Here we examine what that would mean for Irish households.
Interest rates have been at record low levels for over a decade but the recent rapid increase in inflation means the period of ultra-cheap money may be coming to an end.
So, are interest rates going to increase this year? If so, when? And by how much? And how will it impact your pocket?
But first, let’s talk about inflation, which is what's been driving all this recent talk of an increase in rates…
Ireland is in the 19-country Eurozone, which means the European Central Bank (ECB) sets our interest rates.
The main goal of the ECB is price stability. This differs slightly from other central banks (such as the Federal Reserve in America for example, which also focuses on wider economic objectives such as low employment and economic growth).
The ECB defines price stability as an inflation rate of close to, but just below, 2%.
Up until recently, Eurozone inflation had undershot its target for years and the ECB was actually more concerned about deflation than rising prices.
As a result, it slashed its main lending rate to 0% several years ago to help stimulate economic growth and it hasn’t come close to increasing rates since.
It also reduced its so-called Overnight Deposit Rate to -0.50%. This is the rate it charges banks for keeping money on deposit with it. In other words, Eurozone banks are now being charged for keeping any excess money with the ECB.
However, over the past few months, the inflation outlook has changed dramatically.
Eurozone inflation is now running at 7.4%, over three times the ECB target, and its highest level since the euro was created over two decades ago. In the US, inflation hit a staggering 8.5% in March - its highest level in over 40 years. And in the UK, inflation is set to hit over 10% by the end of the year.
Why is inflation on the rise?
A main reason for the uptick in global inflation is rapidly rising energy prices, which are at record levels.
Covid forced many industries into lockdown for much of 2020 and early 2021 and this disrupted delicate global supply chains. So as restrictions eased and economies reopened, severe supply chain bottlenecks arose which put upward pressure on prices in industries everywhere. The energy market was badly affected but so was the production of things like micro-chips, which are used in everything from laptops and smartphones to cars and high-tech fridges. This then fed through into higher prices for these items.
In recent months the war in Ukraine and the threat of an embargo on Russian gas and oil has sent energy prices skyrocketing even further.
Continued strict Covid lockdowns in China, which manufactures many of the world's goods, have slowed the return to normal.
Closer to home, Brexit is also having an impact on prices, particularly in the grocery sector, as new tariffs and charges make importing food and drink more expensive. A shortage of lorry drivers is also playing havoc with transport costs in many parts of Europe, which feeds through into higher prices too.
Around this time last year, it was forecast that inflation would shoot higher over the coming year before quickly falling back, so there was little talk of a rise in interest rates.
However no one expected inflation would go nearly as high or last quite so long. In other words, inflation now looks to be less ‘transitory’ or short-lived than previously forecast.
This is what is fuelling talk of an increase in rates to help take the heat out of the economy and reduce inflation to more comfortable levels.
Where have rates been increased?
In the UK, the Monetary Policy Committee has increased rates four times to 1% since last December and it's expected to increase rates to close to 2% before the end of the year.
In the US, at the start of May, the Federal Reserve increased rates by 0.5% to 1%, the first time it has increased rates by more than 0.25% in one go since 2000.
The Australian and New Zealand central banks have both recently hiked interest rates too for the first time in years.
So the ECB is behind the curve when it comes to lifting borrowing costs.
When will interest rates increase?
Financial markets had been predicting an increase in rates by the ECB from the middle of this year.
However that seems unlikely.
Firstly, the ECB has been buying trillions of Eurozone Government bonds (including Irish ones) since 2015 to help keep government borrowing costs low.
This bond buying is expected to last until summer - however the ECB can’t raise rates before it ends its bond buying program.
Secondly, as mentioned above, the ECB overnight deposit rate is currently -0.50%. Any movement in rates from the ECB will be to this rate first and foremost (most likely two 0.25% increases to return it to zero).
So in short, it’s likely to be near the end of the year before we see an increase in the ECB’s main lending rate. Though it's been coming under increasing pressure to move more quickly.
“The idea that we could hike interest rates in June looks very unrealistic to me. I certainly think there’s a bit of difference between the calendar we’re working to, and the one some market participants may have in mind.”
- Central Bank Governor, Gabriel Makhlouf
How much will rates increase by?
Any increase in rates is likely to be small and gradual.
We might see a quarter point increase in November or December of this year followed by another quarter point increase a month or so later. However the ECB is likely to increase the overnight deposit rate a few weeks before this.
So around this time next year, rates are likely to be only 0.50%. And they may increase to 0.75% or 1% by the end of 2023.
However it all depends on how the inflation situation unfolds.
If inflation stays higher than the ECB’s 2% target for longer, then the EBC might have to increase rates further.
However if inflation falls back quickly later this year - as is still forecast by some - the ECB may not raise rates at all (other than its overnight deposit rate). However this is looking increasingly unlikely.
How will an increase in interest rates affect me?
The main consequence of an increase in rates will be higher mortgage repayments. Already, some lenders such as Avant Money and ICS Mortgages have increased some of their fixed rates for new customers in recent weeks.
Existing mortgage holders on a fixed rate won’t see an immediate change to their repayments - however when they come to the end of their fixed-rate period they will be faced with higher roll-over rates.
Those on tracker mortgages or variable rates could see an almost instant increase in their monthly repayments once the ECB starts hiking rates.
For someone with €200,00 remaining on their tracker mortgage over 20 years – currently paying a margin of 1% - they’re looking at an increase in repayments of around €45 a month if the ECB raises rates by 0.50%.
If you’re an average first-time buyer borrowing €250,000 over 30 years at the average rate of 2.78% - a 0.50% increase would add around €70 a month to your repayments (if you’re on a variable rate).
So these aren’t huge sums of money. However if rates were to eventually return to more normal levels - say 3% or so - that €250,000 mortgage would be over €400 more expensive each month!
Having said that, given the huge disparity between mortgage rates in Ireland and the rest of the Eurozone at the moment (the average rate in the Eurozone is just 1.46%) as well as half-decent competition in the mortgage sector at present, there is potentially room for Irish lenders to absorb a small rate increase.
An increase in rates may also lead to higher borrowing costs for car loans or people doing home improvements and retrofits.
To fix or to vary?
As rates look set to start increasing, many homeowners who are currently on trackers or variable rates might be thinking about moving to a fixed rate.
Fixed rates have become increasingly popular in Ireland in recent years and over 80% of all new mortgage customers now choose a fixed rate.
Fixed mortgages provide certainty in a period of rising interest rates. And almost uniquely in Ireland, are lower than most variable rates too.
So you’re getting financial stability and a better mortgage deal. A real win-win.
What’s more, fixed rates of up to 30 years are now on offer from some lenders meaning you could fix for your entire mortgage.
However, if you have a tracker, given they’re such good value, even as rates begin to increase, you’ll still usually be far better off staying on a tracker.
But if you’re on a variable rate, check out our guide on the pros and cons of each type of rate to see whether it’s a good idea to fix your mortgage.
Will there be any winners?
If you’re a saver then an increase in rates will probably be welcomed.
At the moment, Irish households have a record €136 billion or so on deposit with banks and lending institutions. And much of this is earning little to no interest.
In fact, some banks are even charging negative interest rates due to the negative overnight deposit rate as discussed above.
So an increase in interest rates might mean savers finally receive a return, however small, on their money.
The Credit Unions should also be happy.
Credit Unions park their members’ savings with banks. But as mentioned, some banks are charging negative rates on accounts, particularly those with big savings.
This has caused a huge headache for the Credit Union sector as it is costing them money and in many cases has forced them to stop accepting members' savings.
The housing market
An increase in rates is also likely to cool the housing market. However it’s unlikely to benefit homebuyers much as any benefit from a drop or slowdown in prices will be outweighed by an increase in mortgage repayments due to higher rates. However it should help prevent a housing bubble.
More normal interest rates will also benefit people saving for a pension or approaching retirement.
When you come to retirement, you usually have the choice of purchasing an annuity (an agreed monthly pension amount) for the rest of your life with your savings. However annuity rates have fallen drastically in recent years as interest rates have hit rock bottom - in other words, people are getting a far smaller pension for every €10,000 of savings than they would have a decade or so ago. A rise in interest rates will make things slightly better.
Take a look at our beginners’ guide to pensions to learn more.
Is an increase in rates the right solution?
Usually when inflation skyrockets it’s because an economy is growing too quickly or has got ‘too hot’.
Thus, the usual response is to increase interest rates to help take some demand or ‘heat’ out of the economy.
However, many argue that the recent uptick in inflation isn’t due to demand-side issues. It’s due to supply-side constraints, transport issues, and rapidly rising energy prices - problems over which the ECB and governments have little control. And the ECB seems to have acknowledged as much.
Thus, increasing rates may simply put further financial pressure on struggling households without solving the problems that are actually causing inflation in the first place.
Our monetary policy cannot fill pipelines with gas, cannot clear backlogs at ports and cannot train more lorry drivers.
- European Central Bank Chief, Christine Lagarde
How to combat rising inflation
If you’re looking to fight back against the rising cost of living, we’re here to help. As mentioned above, the energy crisis has had a significant impact on inflation, but the good news is that energy is one of the easiest household bills to save on.
For more savings tips, take a look at our blog on how to beat rising inflation.
Get in touch
Are you worried about rising interest rates? Do you think they should increase? We’d love to hear your thoughts!