The Executive Board of the European Central Bank (ECB) decided to raise euro interest rates by 75 basis points at its monetary policy meeting held on 8 September. The response to a new record annual inflation level in the euro area in August (provisionally 9.1%) is the highest rate hike since the creation of the ECB and the introduction of the euro.
So far, the record for a simultaneous rate increase in the euro area has been 50 points. Such increases have occurred three times so far: in April 1999, June 2000, and July this year (the most popular increase in the past was 25 points and was implemented 16 times). With this step, the increase of euro interest rates by ECB has not ended but will continue.
The latest ECB GDP and inflation forecasts (Figure 4) were also announced at the September meeting. The evolution of energy prices and supply challenges, especially in Europe, price pressures in the service sector following the opening of the economy after the pandemic, rising wages, and the depreciation of the euro required an upward adjustment of inflation forecasts (to 8.1% this year).
Thanks to positive surprises in economic data in the first half of the year, ECB raised its GDP forecast for this year to +3.1%. Due to energy supply challenges, high inflation, and deteriorating consumer sentiment, however, the GDP forecast for 2023 was lowered to +0.9%. According to ECB, a recession next year is only expected in the worst-case scenario if there are problems with the supply of energy resources combined with a cold winter.
Conclusions regarding loans
The question here is whether raising interest rates is a bitter cure for inflation, because the bitterness of borrowing rates is there while there is no promise of lower inflation in the near future. One thing is certain, however: we will not see borrowing costs as low as they have been for the past eight years (if ever).
The ECB is on a rate hike path from which it has no intention of deviating so far. As for future rate hikes, the ECB governor did not give any specifics at her press conference, only promising that rates will be raised in the next one to four meetings (such an answer was “pulled out” by reporters at the press conference) and that decisions will be based on current data. The next meeting of the ECB will be held on 27 October, and another rate hike seems all but certain, which means a further increase in borrowing costs, although the pace of cost increases may slow. Since most of the previous interest rate forecasts for the future can be thrown in the wastebasket, there is little point in trying again to guess how exactly loan commissions will rise.
As a consolation, the market currently seems to be signalling a 3-month Euribor rate that is moving toward 2.5% (on 8 September, the 3-month Euribor rate was 0.836%), which is lower than, for example, the expected increase in U.S. dollar interest rates. It is also important to note that the market signals have never been accurate, as no one really predicted an interest rate increase above 1.5% in the spring.
The current predicted 0.836% increase in the 3-month Euribor is equivalent to about another 1.6% today, and for a EUR 100,000 loan, interest payments would increase by about EUR 1,622 (~EUR 135 per month) over the course of the year if the principal is not repaid. However, since in Latvia the repayment of the loan principal also accounts for a significant portion of the monthly payments, the forecast for the increase in interest costs in euros is lower. These are the figures after the previously increased costs. However, since the loan terms and the interest rates applied are so different, the results would be different for each borrower.
Other conclusions
It is the positive euro interest rates in the market that are bringing the long-forgotten deposit market back to life. Just as negative interest rates did not apply immediately or to everyone, it will take some time for positive interest rates to make an impact on the market.
Falling sentiment indices, high inflation, and rising interest rates increase the risk. Since the price of money conditionally has two components - the acquisition price and the risk price - it is also possible to "accelerate" the cost of new loans in the market if the above two components grow.
While household deposit growth has slowed in recent months, it is still rising, which means that the economy can withstand a combination of inflation and rising interest rates. For Latvia, the biggest challenge is not the upcoming winter, which can be weathered mathematically, but the gap between high- and low-income households, which has widened in recent years. The ECB also recognises the need for targeted support for those most affected by record high inflation.
Although the bitterness is already palpable, it is hoped that the ECB "cure" will be successful in bringing down the inflation rate, as high inflation is an undesirable "disease." Unfortunately, raising interest rates (and also regulating the money supply) is the only "cure" that the ECB can give, but the ECB has no power over the periphery of the energy market.
Andris Lāriņš
SEB Head of Finance market department
