The next cost headache for small business owners, including farmers, will be the cost of bank loans. Interest rates are rising and both the Federal Reserve in the US and the Bank of England announced increases in official rates last week.

In Ireland, mortgage rates have begun to creep up and so have interest rates on Government borrowing. A hike in retail rates on ordinary bank loans is next. The war in Ukraine has deflected media and political attention from these developments, which would have attracted lots of airtime in more normal circumstances.

The COVID-19 emergency has peaked and central banks are beginning to unwind the monetary support they had been providing. As governments expanded emergency spending from early 2020, the central banks bought up the resulting new government debt, placing a lid on the interest bill faced by governments.

Printing money

They have been printing money in effect. It was never intended that this liquidity boost would last and it was acknowledged that there would be inflationary consequences if the easy money regime became normalised. Virtually all major central banks have a formal target of keeping consumer price inflation at or below a figure around 2%. They had been successful until last year but there have been sharp increases almost everywhere.

The authorities began to signal in the middle of last year that the easy money policy would be curtailed gradually, drawing comfort from the belief that the uptick in inflation would prove to be transitory. The inflation spike was initially attributed to once-off increases in energy prices which would wash out of year-on-year price indices, and to COVID-19 interruptions to supply chains which would not prove permanent either.

Complacent

This looked complacent even before the Russian invasion and central bank analysts have been back-tracking on the ‘transitory’ narrative. The Federal Reserve was the first major central bank to take action. It has raised official interest rates at each of the recent meetings of the Federal Open Market Committee.

The result is that short-term wholesale market rates have increased by almost a full percentage point. So have US Treasury bond yields as the Fed’s support for the market is withdrawn and alarm at the spike in inflation in the US has ensured political acceptance in Congress. The Bank of England has embarked, a little later, on a similar policy path.

For Ireland, the stance of the European Central Bank in Frankfurt is what matters. In a common currency area, the national central banks are concerned mainly with licensing and supervision of lenders, and there is just one centralised monetary policy. Interest rates and inflation rates are not free to diverge very much from the eurozone norm.

The ECB had been firmly in the ‘transitory’ inflation school until recently but has now signalled greater concern and a willingness to follow, eventually, where the others have led. The emergency Government bond purchases by the ECB are in the process of being phased out and the markets expect that official interest rates will be raised as soon as the final quarter of 2022. The low cost of Government borrowing in Ireland in recent years reflects ECB policy and it should not be taken for granted when the policy changes at the ECB are implemented.

The war in Ukraine alters the central bank policy climate in two conflicting ways. There is a direct boost to consumer prices due to energy costs: other things equal, this would expedite the tightening of monetary policy. But there is a renewed threat to the strength of the economic recovery which points to the continuation of macroeconomic policy support.

Interventions

Governments, including the Irish Government, have responded with interventions which will slow down the rectification of budget imbalances, through tax reductions in the energy sector, extra provision for dealing with refugees and other measures.

The extra borrowing must be financed. The desired speed of monetary tightening is being pulled higher by the inflation worries and lower by the risk of a general economic slowdown. The direction of travel has not changed, however, and there will be consequences for Irish policy.

Since much of Ireland’s Government debt is at fixed rates and has long maturity dates, there will be a limited immediate impact on the budget debt service burden. But maturing debt is re-financed at prevailing rates each year and new borrowing is needed to fund the deficit.

Eventually, higher borrowing costs will catch up. Lenders know this and could become nervous about the heavily indebted eurozone countries. Mortgage rates will be affected and there is already evidence of hesitation from non-bank lenders in committing to the Irish market.

Events in Ukraine will determine the pace at which interest rates rise but the course is set. The easy money period is coming to an end in Europe and in Ireland.