Understanding: interest rates

The European Central Bank (ECB) just announced they will reduce the current interest rate from 3.25% to 3.00%. It’s always big news when a central bank changes their interest rates for reasons that I vaguely understand. I know for example that the rates on savings accounts are mostly dependent on the central bank interest rate, and that low interest (roughly) equals cheaper money (roughly) equals more money being invested into the economy? Take what I just said with a massive grain of salt, as I’m now going to try to understand what interest rates are all about.

Central banks, commercial banks and types of interest rates

Let’s start off with the interest rates we see in our savings accounts. In Belgium, the best savings account you can get at the moment seems to be the “vdk bank Ritme” account with a rate of 3.15%. Remember, the ECB rate as of now, 14 December, is 3.25%. How are the two related? Instead of basing our information off what the media says, let’s go straight to the source: the ECB’s website where you’ll see a table that looks the one below.

We can see there is not only 1 interest rate, but multiple:

1. The deposit facility rate which is “the rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem at a pre-set interest rate.” Just like how we consumers can deposit cash at a commercial bank savings account at an interest rate of 3.15%, that bank can also deposit cash at the central bank and receive an interest rate of 3.25%.

2. The fixed rate is falls under the category of “main refinancing operations”, which the ECB defines as the following: “The main refinancing operations rate is the interest rate banks pay when they borrow money from the ECB for one week.” Again, just like how we can borrow money from a bank, the bank can also borrow money from the central bank. The rate at the moment for borrowing is 3.40%.

3. Lastly, the marginal lending facility rate which is “marginal lending rate is the rate at which banks can borrow money from the central bank against collateral for a period of one day”. Similar to the fixed rate, the marginal lending rate is an interest rate for borrowing, only this time it’s a loan for a shorter amount of time.

A central bank offers commercial banks many of the same facilities that commercial banks offer us as consumers. Depositing money and borrowing money, those are also things commercial banks do with the central bank. So when you deposit money to your bank, your bank can also deposit that money at the central bank.

It’s no coincidence that the best savings rate you can find at a commercial bank is just below the central bank rate: the difference between the two is what the bank pockets to pay for their operating costs and hopefully for them, to also turn a profit. Often, the rate you’ll find at your bank won’t be only slightly below the central bank rate, but probably a lot lower than the central bank rate.

Interesting trend from some neobanks and brokers in the EU: some of they do just simply pass on the ECB rate onto consumers! The broker Trade Republic currently offers a 3.25% interest rate on cash balances up to 50 000 EUR. Why? My guess is because by getting people to deposit their money there even if it’s just to save that money, the likelihood that that person also uses their brokerage platform and trades with that money goes up. And when they trade, Trade Republic gets money.

You might also notice that the interest rate for depositing money is always lower than the rate for borrowing money. This is for a simple reason: if you could get more money from depositing money to your savings account than what it would cost to borrow money, you would be able to borrow money, put it in your savings account and effectively get free money.

Inflation

Another thing you might notice about the table above: interests rates change. For the past 2 years, they’ve been gradually going up, and now back down again. Changing interest rates is often part of a central bank’s monetary policy, which is a way of “guaranteeing price stability” or controlling inflation.

Inflation is when prices of goods and services increase across the board. If you paid 100 euros for something a year ago and inflation on that something has been 5%, then it will now cost 105 euros. With those same 100 euros, you would now not be able to purchase that same thing again. So your money isn’t able to buy you the same amount of goods and services as it used to. In other words, it’s now worth less.

For the ECB, the measure of inflation is the Harmonised Index of Consumer Prices (HICP). It is calculated using the average basket of goods and services that a household in the Eurozone purchases. Another way of interpreting “guaranteeing price stability” is getting inflation around 2%, which is what a healthy economy is said to have. I have tried to understand why 2% is a good aim by first understanding why other inflation rates may not be good:

• 0% may seem like actual “price stability” at first, but by having no inflation, there isn’t actually much incentive to use your money. If you’re looking at buying a car today but end up buying it a year later, there’s no “punishment” because the price of the car will still be the same. There’s no sense of urgency. This is not ideal for an economy: ideally you stimulate people to spend money, because spending money pays people’s salaries and generates revenue for companies.

• Inflation higher than 2%, say 5%, also incentives you to do something with your money. But if your salary isn’t increasing as much as inflation, which is likely, it might become harder and harder to pay for everything. It also becomes harder to save money, not only because you have less money left after paying for everything, but also because the interest rate on your savings account won’t be keeping up with inflation. So this puts you in a tough spot.

• Deflation, when inflation goes below 0%, is when prices go down. Again, this might seem great: things getting cheaper should be good for consumers. You can now buy more with your money than you could a year ago. However, think about why prices would decrease. It is often a symptom of an unhealthy economy such as one where the supply is higher than the demand or in other words, where consumers aren’t spending enough. As a consumer, you probably wouldn’t want to purchase an expensive asset either such as a car if you know it will be worth less in a year. Again, that is not ideal for an economy.

So when inflation is too high, consumers may struggle to keep up with the increased cost-of-living and may end up spending less money. But when inflation is too low, or even negative, consumers may not be spending enough money because they are worried about their assets going down in value. This is why a 2% inflation rate seems like a sweet spot: not high enough that consumers wouldn’t be able to keep up with it and not low enough that consumers feel like they’re better off not spending their money.

The relation between interest rates and inflation

The way central banks like the ECB try to get inflation to be around 2% is through their monetary policy. A large part of that monetary policy is changing interest rates. How interest rates and inflation are related seems actually relatively easy to explain:

• A low interest rate means it’s easier to borrow to money. Individuals and companies can then borrow money, increasing spending from consumers and investment into the businesses. Because the economy is doing well, inflation starts rising.

• A high interest rate means it’s more difficult to borrow money. Consumers will start spending less and being more careful with their money, as well businesses. This will causes inflation to go down.

So, to summarise:

• Central banks offer commercial banks the same types of services that commercial banks offer us.

• The interest rate for borrowing money differs from the interest rate for depositing money.

• Central banks change interest rates as a way to control inflation.

• A “healthy” economy should have an inflation of around 2%. Too high means consumers may end up buying less because everything has become too expensive, and too low means consumers don’t want to put their money into assets that will be worth less in the future.

• Lowering interest rates makes money easier to borrow, encouraging consumer spending and investment into businesses, thus stimulating the economy and causing inflation to rise.

• Increasing interest rates makes money harder to borrow, slowing down the rate of spending from both consumers and investment from businesses, slowing down the economy and causing inflation to go down.

Sources

• https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html
• https://www.ecb.europa.eu/ecb-and-you/explainers/tell-me/html/mro.en.html
• https://www.dnb.nl/en/the-euro-and-europe/the-ecb-s-monetary-policy/ecb-interest-rates/
• https://www.bde.es/wbe/en/areas-actuacion/politica-monetaria/preguntas-frecuentes/politica-monetaria-y-estabilidad-precios/que-es-la-deflacion-y-por-que-es-importante-evitarla.html
• https://youtu.be/Tu7G4btt4WU?si=SLRnhbhTOG8IFXPf