Many people around the world, as well as those in Latvia who are still planning to borrow money, will spend the beginning of the year waiting for the first interest rate cut from the European Central Bank. Some market participants think the ECB will cut interest rates at its meeting on 7 March. But will it?
In light of the current assessment, the Governing Council of the ECB believes that the key interest rates are at a level that, if sustained, would contribute significantly to inflation returning to 2% within a reasonable period. The Governing Council’s decision on interest rates is contingent upon an assessment of the inflation outlook based on economic and financial data, the dynamics of core inflation, and the effectiveness of monetary policy transmission.
In the current market climate, we have mixed feelings about interest rates (cheaper loans). On the one hand, a possible rate cut is “just around the corner”, on the other hand, the rate cut, if it comes, will not be a consequence of the good news. While the battle for a convincing inflation rate of 2% takes centre stage, in the background there is also the issue of economic growth, for which there is no prospect of an upturn for the time being, especially if the ECB delays the rate cut.
An interesting situation has arisen in Latvia concerning euro interest rates. The ECB sets the same monetary policy for all 20 Eurozone countries, while their governments pursue 20 different fiscal policies.
It is the decisions of Latvian politicians that will play a greater role in the Latvian population’s mortgage interest costs this year than the central bank’s monetary policy. On the eve of the ECB’s rate cut, Latvian politicians made it easier for the Governor of the Bank of Latvia to support lower euro interest rates at ECB meetings in line with Latvian inflation data.
Latvia has already made an aggressive rate cut for a year
While the behaviour of the Eurozone’s average inflation numbers prevents the ECB’s management from relaxing and keeps interest rates at a high level, theoretically, against the background of Latvia’s much lower inflation rate, the Bank of Latvia’s management should side with doves* and talk about lowering euro interest rates.
However, instead of the central bank, a very large part of Latvia’s loan portfolio has already been subject to interest rate cuts by the Budget Commission, MPs, and the President, setting a 30% discount on interest payments.
Figuratively speaking while the ECB kept the euro benchmark interest rate at 4.50%, Latvia has already implemented an aggressive interest rate cut of 135 basis points (30% of 4.50%) for one year. In real life, the basis points are different for everyone, as mortgages use different Euribor rates for different maturities plus different bank surcharges (on 25 January 2024, the one-year Euribor rate is 3.662%, so the cut in the Euribor portion will be 110 basis points).
At the end of October 2023, the mortgage portfolio in Latvia was EUR 4.7 billion and the vast majority of this portfolio will be eligible for the 30% interest compensation.
The “discounts” applied do not improve the situation on the new mortgage market in any way, as there are no discounts for those who applied for a loan after the end of October last year. There is also no compensation for mortgage loans over EUR 250,000 and other types of credit (leasing, consumer credit). This segment of the credit market and companies can only wait for possible interest rate cuts from the ECB, which the market has already rushed ahead of if you look at the Euribor data.
Most of Latvia's money belongs to a small minority of individuals
At the moment we can only talk about the money that was in the bank accounts until November last year (the data for December will be published in the last week of January). The data is not encouraging as the annual change in household deposits has been negative for 3 months in a row.
Less money in bank accounts and still positive inflation means less money to spend on fewer goods and services - this has been reflected in the year-on-year change in Latvian retail sales in recent months. Of course, part of the decline in deposits is due to the outflow of money into securities - funds, shares, and bonds. In December 2023, individuals’ investments in savings bonds issued by the Treasury alone totalled EUR 250 million.
Considering that wage growth outpaces inflation and optimism grows about the improvement in people’s purchasing power, I don’t think the average indicators paint the whole picture. Most of the money belongs to a minority of the Latvian population and the same is probably true for income growth, so we need to look at a detailed analysis or at least median figures. Solutions need to be found to prevent the gap between high and low-income households from widening.
An interesting fact: there is good news in 2024 for some mortgage borrowers who are entitled to interest rate relief and who were able to save last year and put their surplus money into deposits or savings bonds near the interest rate peak. For example, if you bought a savings bond with a 4% coupon (or interest rate) in 2023 and the total interest payment on your mortgage this year is less than 5.7%, you could find yourself in the relatively rare situation where the interest you pay on your loan is lower than the interest you receive on your savings bond (or deposit) for a year. 5.7%-30% = 3.99%, i.e. the cost of the loan is 3.99% and the return on the savings bond or deposit is 4%.
The higher the interest rate received on the investment and the lower the interest rate on the loan, the greater the pleasure. Due to the interest rate differential between deposits and loans, such an opportunity does not usually arise on the financial market through simultaneous activity on the loan and deposit side and is generally only possible if transactions are made either over different periods or over different maturities.
The ECB’s Governing Council will decide on interest rates again on 7 March in Frankfurt, whereas the US Federal Reserve will next meet on 30/31 January.
*A wide variety of designations used by central bank officials exist in the market, based on the views they hold regarding what monetary policy should be implemented. “Hawks” are generally in favour of restrictive policies that curb inflation and growth. Conversely, doves are in favour of “looser” policies that promote growth and inflation. This is an example of the categorisation by the ECB officials.
