Don't Draghi it out, give us a rate cut!

Don't Draghi it out, give us a rate cut!

Mario Draghi

Will the European Central Bank (ECB) be lowering rates below 1%? If they do will it make any difference to the Irish market? Today we look at some of the key considerations and how it will affect you if rates are lowered.

In simple terms, interest rates affect different people in different ways, people with certain types of debt become better off, some with debt see no difference, and the same goes for savers, some benefit while others lose out – we’ll look at these scenarios along with some background.

Firstly, consider where this rate cut may come from. The current ECB President Mario Draghi is a fairly plain speaking guy for an economist, and only last night he warned that the euro currency union is “unsustainable” without stronger political and financial ties, and called for a new course to save it from a crippling debt crisis. Certainly cause for concern given the normally guarded language the central bankers speak in – and at times of financial crisis a common central bank reaction is to drop rates.

Currently the ECB interest rate is at an historic low, Draghi surprised everybody when he took office by promptly lowering rates (people figured he wouldn’t as former president Jean Claude Trichet didn’t allude to any forthcoming rate cuts as he left last October). Draghi is not an inflation hawk to the same degree as Trichet was, and even Jean Claude would countenance a rate cut now given that inflation has dropped below 2% in Germany.

The ECB mandate (outside of money supply) is to keep inflation ‘close to, but below 2%’, in April the Euro area inflation rate fell from 2.6% to 2.4% – the trajectory is clear, as is the exchange rate with the Euro almost matching a two year low against the Dollar (which is still the worlds safe haven currency).

That a rate reduction is likely is a commonly held belief, the question is perhaps about ‘when’. Some economists think that it will be delayed until after Greek elections, and others are saying that some ongoing drops in inflation will be needed to justifty a rate cut. Personally I wouldn’t be phased if Draghi once again took the markets by surprise with a pre-emptive rate cut.

This doesn’t spell disaster (lower rates are designed to aid recovery, they are not a portent of guaranteed glum future), many of the largest economies in the world are already ahead of us – The US Federal Reserve rate is 0.25%, in the UK it is 0.5%, and in Japan it is 0.1% and in Switzerland (also considered a ‘safe’ nation currency) it is 0.25%.

Even in growing economies like Brazil they are getting rate cuts (expected 0.5% reduction to 8.5% this week), but they have strong inflation and that makes the ‘real’ interest rate (where inflation is taken into consideration) about 3%.

How will you be affected? It depends, if you already have a mortgage then chances are a rate cut will be to your benefit because 400,000 of the 764,000 mortgages are on tracker rates where rate changes are embedded in the price.

If you have a mortgage then a 0.25% rate cut will generally knock about €13 off your monthly payment for every €100,000 borrowed over 25 years, so if your loan is 200k that’ll be €26 a month or just over €300 a year in reduced costs.

That leaves borrowers on fixed rates (who won’t see any change) and those on Standard Variables who probably won’t get the benefit passed on.

Last November the state bullied AIB into passing on a rate cut – after they didn’t pass on rate increases, making AIB standard variable mortgages better than trackers because when rates go up the price doesn’t increase but when rates go down they do! This was a political construct and a mistake, meaning AIB are now lending at loss making prices, and we have a crazy situation where a regular person can borrow from a state owned bank for cheaper than the bank or state can borrow from anywhere else, thus giving individuals better credit conditions than the banks or the country.

One of the few ways for a bank to get that margin back (because increasing rates is really unpopular) is to avoid passing on rate cuts. Ptsb probably will pass it on, everybody else won’t.

That is borrowers covered, next is how it will affect savers. If you are on the other side of the equation and have savings then you are either on a fixed term account where your price is already guaranteed, or you are on a variable savings rate in which case your savings rate would drop.

The most popular fixed accounts are for 12 months (thus it is a term with high competition) and for them it only becomes an issue at ‘rollover’, for those on variable savings it could be a good time to switch – fast! – into something fixed. Alternatively, you can do nothing but chances are your interest rate will drop.

Chances are interest rates will drop anyway, there are many indications coming from banks that deposit pricing has gone astray and they all want to drop their rates but are afraid of losing their deposits to other institutions.

The only thing I can be certain of is that this rate cut will be used as an opportunity by the banks to pay their depositors less, and to gain some margin in variable rate holders, so plan accordingly!

@karldeeter

 

 

 

Irish Mortgage Brokers

There are 7 comments for this article
  1. Paddy at 10:03 am

    Karl,
    The words ‘subsidized state support’ are rarely heard in the world of a saver. Rather, it is the all too common ‘below inflation returns’ and ‘25% DIRT tax’ that spring more easily to mind.
    ‘Subsidized state support’ is however a term often associated with mortgage tax relief, a fiendish device whereby those who can not afford to buy a house, or chose not to pay the outrageous prices demanded in this fair land subside those who chose to pay the high prices. ‘Subsidized state support’ is also extended to the afore mentioned weddings, cars, honeymoons, etc. through mortgages of up to 120% of property value cunningly wangled by the more innovative mortgage broker and client combinations.
    But all this fades to insignificant when compared to the generosity of the ‘subsidized state support’ available to professional property investors under Section 23 Relief (January 2008, revised June 2010). By means of the provisions of this act, many the most wealthy in our society avoid the payment of much, and in some cases all income tax…….now that’s what I call a proper case of ‘subsidized state support’

  2. Karl Deeter Author at 12:37 am

    @PaddyPrudent: There is a diversion from the argument in saying ‘everybody should save’. I totally agree with that, the question is whether savers should be subsidized by the state in the form of extremely high deposit rates which is a different matter.

    And yes, my firm does earn money via commissions, fees and the like – which is known – but it is something that is more affected by lending volumes than house prices. Which still doesn’t go towards answering why savers should get subsidized state support.

  3. Tony M. at 5:34 pm

    Why a cohort of noisy, greedy, foolish people who wangled loans of up to 8-times their joint income to finance a lifestyle (house, wedding, cars, honeymoons, etc;loan amounts they clearly couldn’t afford managed such a wangle (such big loans) is probably the key question in all of this current mess.

    I will now venture to query why those that are not so noisy, greedy, or foolish people are currently and persistently being asked to wangled loans of up to 5-times their joint incomes to finance a future home, and a meagre lifestyle .

    I think the answer to both these why is that peope were and are forced into situtations they cannot afford but cannot avoid by those noisy, greedy…

    Currently house prices are being kept inflated. Their value is being dictated by the NAMA crew and … and not market forces of supply and demand.
    There are the business minds and ethics behind the institutions in this country that deliberately create the scarce resouce environments where individual and household over-indebtedness flourishes.
    There is the problem and the solution…

    Comments, Criticisms and corrections welcome.

  4. Paddy, prudent at 2:58 pm

    Karl, “everybody” does not have a whopping property loan, but everybody is or should be putting money in a saving account, pension, etc. You wouldn’t happen to be working in a commission based industry, would you? But then again, if I my personal interests were best served by high house prices, I’d be singing the same song.

  5. Sean not so prudent at 1:08 pm

    Good news that tracker rates will come down but what about the news that banks are coming out with schemes to help mortgage holders in distress? I can’t wait to hear what they have dreamt up but I bet my house on it that not one of them will suggest some form of debt write down!

  6. Karl Deeter Author at 12:37 pm

    @PaddyPrudent I don’t see why savers should be rewarded using your thesis of right or wrong – because the bailed out banks are using tax payer funds to support those deposit rates which is an explicit transfer from everybody to savers.

    As for ‘sub inflation rates’ – the history of deposits is that they were usually at best on par with inflation, the current market is out of sync in that respect and dropping rates will be a return to business as normal.

    Either side of the argument, the situation will evolve the same: banking services will get more expensive, bankers will lose their jobs, deposit rates will drop, borrower rates will rise.

  7. Paddy, prudent at 12:16 pm

    The important issue is that savers get an after tax return of at least 3% above inflation. Why should the sensible majority who do their best to save for their retirement, holidays and deposits on homes be penalized because of a desire for sub-inflation interest rates by a cohort of noisy, greedy, foolish people who wangled loans of up to 8-times joint income to finance a lifestyle (house, wedding, cars, honeymoons, etc.) they cannot afford.

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