Welcome back to our series, where we give you the basics for understanding central banking! In this second blog and video, we take a look at one of the tools most frequently used by central banks to pursue their objectives – interest rates.
In the first blog of our explainer series, we have seen how central banks play a crucial role in overseeing and managing our money system. The European Central Bank (ECB), namely the central bank of the euro area, has the primary objective of keeping prices stable. The key tool it uses to do so is the manipulation of interest rates. How does this mechanism work exactly? Let’s dive in.
What interest rates does the ECB use?
The ECB adjusts three main interest rates to pursue its mandate of maintaining price stability. These rates set the remuneration received on deposits with the ECB, or paid on loans from the ECB. In particular, they are:
- The main refinancing operations rate, which is the interest rate that commercial banks pay to borrow money from the ECB for one week.
- The deposit facility rate, which applies to the overnight deposits that banks hold at the ECB.
- The marginal lending facility, which is the interest rate that commercial banks pay if they need to borrow from the ECB quickly (for example, overnight).
The ECB uses these three rates in combination, and we usually refer to them as the key interest rates or policy rates. Typically, a lower key interest rate can boost economic activity, while a higher rate is used to slow down the economy in a situation of generalised price increases.
What are the effects of the ECB’s rates for people?
So, although the central bank key rate does not apply directly to us consumers, it does apply to the commercial banks and, therefore, has an effect on the rates that the banks charge us. How?
When the ECB raises its rates, it leads to a ripple effect where banks also increase the interest rates on the loans they offer. This discourages consumers from borrowing. For example, the past year of inflation and rate hikes have caused a decrease of the funding granted by banks to both individuals and businesses — the ECB’s recent Bank Lending Survey shows that bank lending conditions have become tighter across all loan categories.
When the ECB interest rates are high, it also means that the ECB pays higher interest to banks on the overnight deposits they hold at the Central Bank. We will delve deeper into what this implies in our next content in the series.
In the opposite situation, when the ECB keeps its rates low, banks consequently lend to their customers at more favourable rates. Since the return on savings also decreases, individuals and businesses are inclined to spend their money rather than save it. This behaviour boosts the economy, encouraging companies to invest and hire more. The ECB follows such an approach in times of economic downturn, as seen post-2008 financial crisis and, more recently, during the Covid-19 pandemic.
Are the ECB interest rates effective?
Interest rate adjustments have long been among the main strategies that central banks use when they aim to stimulate or cool down the economy. However, it is essential to recognise that inflation doesn’t always hinge on changes in consumer demand or people spending too much money.
In the current economic environment, we are seeing a surge in supply- and fossil-driven inflation, which in simple words means that price hikes are largely due to supply-side disruptions and to a fossil fuel–induced energy crisis. In such cases, interest rate changes may not be able to effectively address the root causes of rising prices.
Another problematic aspect of rising interest rates is that in attempting to solve inflation, they create further problems, such as job cuts, declining purchasing power and, in general, greater strain on the economy.
It’s crucial that policy makers consider a more comprehensive set of tools to manage inflation in a multifaceted and ever-changing global economy.
Stay tuned for our next blog if you want to discover more on central banking!