The era of cheap borrowing is over. Households, businesses and governments are all starting to feel the pinch, and things are going to get harder before they get easier.
Having learned the lessons of the global financial crisis, central banks across the world slashed interest rates and flooded financial markets with money as an immediate response to the Covid-19 pandemic in early 2020. Governments spent money like it was going out of fashion in an unprecedented and synchronized global effort to ward off the worst economic effects of the pandemic. On their own terms, these efforts were superbly successful. The Covid recession was mercifully brief and shallow as a result.
Lingering effects of the pandemic, notably including China’s continued zero-Covid policy, caused supply chain problems like shuttered factories and overburdened ports. Input costs increased, and global demand recovered faster than supply as central banks and governments were slow to unwind those economic support measures. There were hopes, and legitimate expectations, that these supply-side pressures would gradually subside, supply would be better matched by demand, and inflation pressures would ease. Policymakers’ hopes have been dashed. Inflation has stubbornly persistent. Having been caught flat-footed, and to avoid inflation becoming entrenched, central banks have now embarked on the fastest synchronized tightening of monetary policy since at least the early 1980s.
If we look at the economy as a car, and central bankers as the driver, then interest rates are like the brake and the accelerator. The brakes were hardly used since the global financial crisis, with the European Central Bank (ECB) having kept its main deposit rate below zero for much of the past decade. Having floored the accelerator in the face of the pandemic, putting the vehicle at risk of careening out of control, they are now trying to jam on the brakes. The challenge is to get the vehicle back under control without bringing it to a shuddering halt. This is complicated by increasingly icy roads (notably Russia’s invasion of Ukraine) and worn brake pads (interest rate changes take up to two years to take full effect).
Already, the Frankfurt-based ECB, which sets monetary policy for Ireland and all other members of the Eurozone, has increased its main interest rates by a cumulative 1¼ percentage at its July and September meetings. A further ¾ point rise is expected at its next meeting on 27th October, while financial markets expect a further ½ to ¾ point increase at its 15th December meeting. This would bring interest rates to what economists call ‘neutral’. Going back to the car analogy, the ‘neutral rate’ is the interest rate at which the central bank is neither pressing on the accelerator nor on the brakes. Economists estimate that the neutral (deposit) rate is currently 1.5-2% for the Eurozone as a whole.
The current expectation, both at the ECB and in financial markets, is that they will have to go further, and actually tap the breaks by further increasing interest rates in 2023. There is disagreement about how far they will need to go: ECB staff think a little, financial markets think a lot. If the expected European recession is deeper than expected, there may not be much need to apply the brakes, however, and it’s not beyond the realms of possibility that they will have to use the accelerator (i.e. cut rates) again before long.
Having recovered strongly post-pandemic, the global economy is already slowing, and is expected to slow further into 2023. Rising prices are a big reason why: because they encourage central banks to hit the brakes and because they weigh on consumers’ real disposable income and demand when they outpace wage increases. Even before Russia’s invasion of Ukraine, the UK was heading into a number of years of weak growth, partly due to the post-Brexit shakeout. The impact of the war, and their recent bout of budget hara-kiri, makes a recession there nearly inevitable, while recovery may be slower than elsewhere. The rest of Europe is heavily dependent on energy imports which have become significantly more expensive. This means weaker trade balances for countries and less money for consumers to spend on other items. These headwinds to growth will be exacerbated by rising interest rate. It will be exceedingly difficult for Europe to avoid a recession, while some economic indicators suggest it has already started in a number of countries.
While the US is not as exposed to energy imports, being a net exporter since 2019, its economy has been running hotter than elsewhere, meaning the Federal Reserve – which sets US interest rates – is hiking rates faster and higher than will Europe. That has a knock-on effect on other economies. Relatively higher interest rates attract capital inflows to the US, so dollars are in more demand. As the US dollar thereby increases in value, other countries see their currencies depreciate, their imports increase in cost, and their inflation rates rise even further. So, other jurisdictions may be forced to increase their interest rates more than they would ordinarily need to so as to minimize this effect.
What does all of this mean for us here in Ireland?
Like most of the rest of Europe, Ireland imports a lot of its energy while also being exposed to interest rate increases. Both our Central Bank and the government note the economy is already slowing, and is expected to slow further in 2023. In many ways, however, Ireland is in a better position relative to a lot of other European countries, and certainly with respect to the Ireland of 2007 on the eve of the financial crisis. Underlying economic growth is stronger than in many other European countries, while our public finances are in better shape. This means the government will likely have room for maneuver in terms of extra cost-of-living measures in 2023. As the Tánaiste acknowledged the day after the recent budget, an emergency budget cannot be ruled out. While government and, particularly, household debt levels are still relatively high, the latter pale in comparison to debt levels back in 2007. Interest rate increases will bite, but to nothing like the extent as would previously have been the case.
So, the Irish economy will continue to slow into 2023. Unemployment will rise. There may be a recession, but it is not a given. However, whatever the macroeconomic statistics may say, it will feel like a recession for most of us. Consumer prices will continue rising faster than incomes, whether from wages or welfare. Living standards are likely to fall faster than at any time since 2009. Every percentage point increase in ECB interest rates will add €83 to the monthly repayment of every €100,000 borrowed on a tracker or, assuming increases are fully passed on, variable rate mortgage. On the plus side, borrowers can take solace in the fact that inflation is eating away at the real value of their debts. Higher prospective mortgage repayments also mean property buyers, whose real incomes are already under pressure, will not be able to borrow as much as previously, even if this will be somewhat off-set by the recent relaxation of lending criteria by Ireland’s Central Bank.
Even though housing supply remains significantly lower than housing need, effective demand – that is, what buyers can pay – is likely to decline. This will inevitably weigh on house prices. That house price growth will slow is inevitable. That house prices will increase more slowly than consumer prices, such that real house prices fall, is likely in 2023. This will leave homeowners feeling less flush, and this less likely to spend. That house prices will actually fall is certainly possible, but not inevitable. Countries like Canada, Australia and New Zealand are already experiencing house price falls on the back of rising interest rates, and these likely have much further to run. But, any fall in Irish house prices will be nothing like the magnitude of the 45% decline we saw between April 2007 and March 2013.