The European Central Bank’s fast track of higher interest rates starts to slow, with an increase of just 0.25% on the 4th of May is a sign that some common sense is beginning to prevail. While it is predicting another 0.25% increase in July, that will depend on industrial output and fears of a recession. If there is a slump or potential recession on the horizon then they may halt further interest rate hikes after the July meeting or they may not increase at all.
The industrial powerhouse of Europe, Germany, has seen production fall further than expected mainly driven by the automotive industry (pardon the pun). The decline was sharp, dropping by 3.4% in March on the previous month. According to Reuters:
“In March, German industrial orders fell by 10.7% from the previous month on a seasonally can calendar adjusted basis, posting the largest month-on-month decline since 2020 which was the height of Covid”.
While the ECB had to play catch-up, did they go too hard too fast? As I mentioned in my previous article, the hawks were pushing this agenda without taking time to reflect and allow for the lag effect that previous hikes may have already tapered inflation. The damage may already be done which will be hard to reverse from a monetary policy perspective and a saving face mindset.
So where are we at? The increase in rates has a negative impact on borrowing costs for individuals and businesses. As the cost of borrowing rises, it becomes more difficult for individuals and businesses to access credit, which can lead to a slowdown in economic activity. To some degree this is what the ECB wants, as a slowdown in economic activity leads to a slowdown in inflation.
Ultimately it leads to a decrease in consumer spending, with consumers less likely to borrow for cars or homes, while business will be less inclined to invest in new projects or expansions. The additional downside to higher interest rates is the strengthening of the Euro currency. When interest rates rise investors flock to Euro-denominated assets, such as government bonds. While a strong currency has its benefits making purchases of goods and services from abroad cheaper, it makes exports more expensive and less competitive.
This could have a negative impact on the export driven economies such as Germany and the Netherlands, negatively impacting their growth. As I have highlighted in the past, an increase in interest rates generally leads to a rise in government borrowing costs. As the ECB continues to raise interest rates, the cost of servicing government debt
will also increase leading to higher deficits and increased pressure on government budgets. This leaves heavily indebted nations open to the debt markets which leads to more expensive debt or debt that cannot be serviced, then in order to service this increase in debt governments cut spending and increase taxes further slowing down economies.
From a construction point of view and I believe we are beginning to see it within the market, decreases in asset prices, offices, housing and stock, funders have moved to safer asset classes which are providing acceptable yields, a German Bund 10 Year Yield will provide 2.45%, a safe bet. In Ireland we have been lucky that we have a budget surplus that is c. €12Bn and over the next four years could be €65Bn in total. This gives the government some leeway to allow them to take a portion of the additional funds and step in to be the project funders where required particularly in the housing Social and Affordable sector.
It is not all doom and gloom, while core inflation remains a bit sticky in the short-term, headline inflation is projected to fall below 3% by the end of 2023 and continue falling during 2024 whereby, we should be at the target 2% by the end of 2024 or early 2025. However, if the ECB continues to increase interest rates after July, because they feel core inflation is still too sticky, even at a low level such as 0.25% this could exacerbate further contraction of GDP growth of the core Euro area countries which has the potential to contribute to disinflationary pressures i.e. a reduction in money supply. The interest rate merry-go-round will continue creating a state of uncertainty or instability in the financial system. Fingers crossed the rational members of the ECB can persuade a halt in July.
Colm McGrath, Managing Director of Surety Bonds
(This article originally appeared in Irish Building Magazine, Issue 3, 2023 )