ECB raised interest rates. What does that mean for you?
The ECB’s Governing Council has raised interest rates for the first time in 11 years, and more increases are likely in the coming months. The explanations below are good way of understanding how the economy works.
Why have we raised interest rates?
We are the central bank for the euro, and it is our mandate to keep prices stable. When prices in our economy are rising too fast – that is, when inflation is too high – increasing interest rates helps us bring inflation back down to our 2% target over the medium term.
Inflation is putting a strain on people. Many are worried that it is here to stay. We keep an eye on these so-called inflation expectations. That’s why we have raised interest rates: to send the message that we will not allow inflation to stay above 2%. That will help keep inflation expectations in check.
What are interest rates?
Interest rates are the cost of borrowing money (it is sometimes said that interest rates are “the price of money”). If you want to take out a loan from a bank, you first have to agree on a certain rate, which is usually an annual rate.
Let’s say you borrow €10,000 at an annual rate of 3%. This means you will have to pay your bank €300 per year in addition to paying back the loan. So, the interest rate is essentially what the bank charges you for lending you money.
It also works the other way around. Interest is the money the bank pays you on your savings, i.e. when the bank „borrows” money from you. For example, if you put €1,000 into your savings account at an annual rate of 2%, at the end of the year you will receive €20 in interest.
What causes interest rates to move?
The interest rates that banks offer people and businesses usually move in tandem with the rates set by the ECB, but they are also influenced by other factors. In a free market economy like the euro area, rates are also determined by the demand for and supply of credit. In other words, how much businesses and people want to spend and invest, and how much credit is available.
It’s similar to other products or services. For example, if many people want to buy bread, but there is not enough bread available, the price goes up.
The same applies to interest rates: when businesses and people want to spend and invest, but they can’t easily get enough credit, interest rates tend to go up, because there is less credit available. In other words, borrowing becomes more expensive. If it is the other way around and people save a lot of their money in the bank, the economy is flush with money – often called liquidity – so rates tend to be low.
How do the key interest rates affect inflation?
In normal times, if inflation is too high because of too much demand chasing too few goods and services, we can raise rates to make credit more expensive. This will cool the economy, calm inflation expectations and bring inflation down.
If inflation is too low – which was the case for a long time – we can lower rates and make credit cheaper to boost investment and demand.
Since Russia’s invasion of Ukraine we have been facing a situation in which inflation is too high but the economy is slowing. Prices have increased a lot owing to the war, especially for energy and food. Many companies are also finding it more difficult to get the materials, spare parts and workers they need for production, which is worsening problems that were already there because of the pandemic.
Raising interest rates alone will not solve all these problems. Higher interest rates will not make imported energy cheaper, stack empty shelves in supermarkets or deliver semiconductors to car manufacturers.
Higher rates keep inflation expectations under control
What higher rates will do, though, is keep inflation expectations under control. If people and businesses think high inflation is here to stay, workers are likely to demand higher wages and employers may in turn put up their own prices.
This is often referred to as a wage-price spiral. We will keep raising interest rates — making credit more expensive and savings better rewarded — to prevent such a spiral. We will make sure businesses, workers and investors are confident that inflation will come down to 2% over the medium term. We will not let expectations of higher inflation become entrenched.
Author European Central Bank. The article can be found here