Chart of the week from DWS. Market participants seem to know which interest rates will be most appropriate than the ECB itself. We try to explain why.
Last week, European Central Bank (ECB) President Christine Lagarde pledged to provide “all rates necessary…to achieve our 2% inflation target in due course”, pointing out that components under underlying inflation rates remain far too high. “We echo this sentiment and continue to expect further hikes, in addition to the 50 basis point increase in the deposit rate to 2.5% in February,” said Ulrike Kastens, Europe Economist. at DWS, “We also believe it is premature to predict the end of the rate hike cycle at this time.”
Perhaps a more interesting question, however, is why so many market participants seem to be much more certain than the ECB itself that they already know what rates will be appropriate. For most central banks, it has been a long time since interest rates have risen so rapidly. Economies have changed since then. Golden rules dating back to Milton Friedman recommend a lag of at least 12 months. Those currently invoking them, however, seem to forget that these estimates often come with a strong caveat, namely that lags tend to be quite variable from cycle to cycle.
In recent years, few current investors have spent much time thinking regarding the dynamics of monetary transmission during hiking rather than easing cycles. They may be forgetting that the Eurozone remains very heterogeneous, especially with regard to the impact of monetary decisions on the different Member States. Our chart of the week illustrates this point in a particularly important area where one would expect higher rates to slow economic activity. It shows the percentage share of variable rate residential loans granted to households in the euro area as a whole, as well as in its four largest economies. In Italy, this proportion (measured in terms of volumes of new residential loans for the purchase of homes) has increased sharply in recent months, suggesting the impact that monetary normalization is likely to have on the slowdown construction in this country. To a lesser extent, this also seems to be the case in Germany.
However, even among the most important countries, there are wide divergences on this measure alone. The precise reason for the persistence of these differences – and of those, even more important, between all the members – has been the subject of several empirical studies in recent years, including by the ECB itself (2). Alas, as a paper calling for more research laments, “our theoretical understanding of the meaning of credit cycles is still very limited.” Or, as psychologist Daniel Kahnemann might have put it, “Our comforting belief that the world has meaning rests on a secure foundation: our almost limitless ability to ignore our ignorance.”
Share of variable-rate residential loans in the total volume of new loans for the purchase of homes
Sources: ECB, Statistical Warehouse, DWS Investment GmbH from 07/02/2023
