Patrick Honohan: Why are interest rates so high – and how exposed is Ireland?
The State’s relatively low debt has insulated it so far. But political turmoil abroad and a speculative AI boom could still hit the economy hard
Over the past few weeks, political unrest in France has led to a sharp rise in the interest rates the French government must pay on new borrowing. Meanwhile, US interest rates have also reached levels not seen for a couple of decades. It’s a big change from only five years ago, when some governments (including Ireland) were able to borrow money at a negative interest yield. Now Ireland has to pay about 3½ per cent annually when borrowing for 10 years, and the German government fares little better. So what’s going on and how much does it matter for us in Ireland?
Although both the European Central Bank (ECB) and the Federal Reserve held back from increasing interest rates at their meetings this week, the general expectation is that their commitment to bring inflation under control will mean some further increases in coming months.
The changing of the guard at both central banks is unlikely to reverse the upward movement. New Fed chair Kevin Warsh defied the hopes of the White House last month when he presided over a rate increase that mirrored the practice of his predecessor in responding to higher inflation with higher interest rates.
The leading candidates to succeed Christine Lagarde, when she steps down early from the presidency of the ECB in three months’ time, do not include any radical advocates of easy money. Even if Dutch contender Klaas Knot is considered more hawkish than his main rival, Spaniard Pablo Hernández de Cos, both are orthodox economists committed to restoring price stability. And high interest rates are a central bank’s main tool for achieving that goal, though unfortunately they are a blunt instrument for dealing with the current bout of inflation, given that its source is not an excess of aggregate spending but war-driven energy shortages.
It’s not just the actions of central banks that influence rates of interest paid by governments and others. Central banks’ policies directly impact short-term interest rates, whereas governments do much of their borrowing at longer term. Long-term interest rates do not normally move in lock-step with the short-term central bank rates. In 2022-23, long-term government bond yields stayed below the peak central bank rates. This time, though, long-term government bond yields have climbed higher than the central banks’ short-term rates.
One obviously important factor in pushing up long-term interest rates is the scale of government borrowing in the world’s largest economies. Among others, the governments of the United States, Germany and China are all running sizeable deficits and have to offer higher interest rates to attract the necessary amount of savers’ funds. This spills over into the cost of borrowing even for governments such as Ireland’s, whose debt has been kept under control largely thanks to the tax payments of a handful of US-based firms.
When the fund managers who are making investment decisions lose confidence in the ability or willingness of specific governments to bring their budgetary affairs under control, they will demand an additional interest rate premium to protect themselves. That’s what’s been happening in France, and also last week in Brazil. Even if the risk of default is not considered high, the potential volatility of political and financial policy developments in those countries drives up their borrowing costs.
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Governments have been joined as heavy borrowers by the so-called “hyperscaler” technology firms building data centres and buying advanced microchips to strengthen their ability to generate artificial intelligence (AI). These firms (including the likes of Amazon, Google, Meta and Microsoft) used to be able to pay for their investments out of profits, but now their construction and investment budgets have exploded well beyond that and they are adding to the global upward pressure on long-term interest rates.
Whereas rapidly rising interest rates were the straw that broke the Irish fiscal camel’s back in 2010, this time Ireland is less affected than others because its debt is relatively low. (That’s what allows it to contemplate early repayment of bailout funds from Europe.) Nevertheless, the flow of Irish tax receipts from those hyperscalers does depend on continuing profit flows. If their huge investments do not pay off, their profits could collapse.
So much for wholesale markets where governments, banks and investment funds operate. But what of the household borrower? The interest rate on the (diminishing) number of tracker mortgages does move one-for-one with the central bank rate, but most other Irish retail interest rates have not reacted to the movements in central bank interest rates as much as would be expected in a more competitive and less impaired banking market.
Irish mortgage rates remained high a decade ago when the main ECB rate went negative, and they increased by only about 1¼ percentage points in 2021-23, whereas the ECB rate jumped by 4½ percentage points. As a result, from being much higher than other euro area countries in past years, the average interest rate on new Irish mortgages is now below the euro area average.
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Savers will also have noticed that, while banks were quick to reduce most deposit rates to about zero a decade ago, they did not increase as much as the ECB rate when it was hiked after the pandemic, and the same has been true this year.
All in all, Ireland has so far been more insulated than many other countries from the remarkable volatility of international interest rates. High interest rates abroad are, however, a symptom of problems – heavy government borrowing, political unrest, highly speculative investments in AI – that may well grow to hit us harder. This could come, for example, in the form of recession abroad weakening global demand for Irish products, or through a collapse in the finances of the AI sector interrupting the flow of corporate tax revenue to Ireland from the US multinational firms located here.
Either way, the best protection is through speeding up the delivery, on a cost-efficient basis, of the infrastructure and public services needed for a prosperous and stable society.
