Key rates and their impact on the economy

Key rates set by the European Central Bank (ECB) rose significantly in 2022 and 2023, yet some clients and investors remain puzzled by them, how they work and their impact on the economy. Lionel De Broux, Chief Investment Officer at BIL explains how these interest rates work and their consequences for your borrowings and savings.

Mr De Broux, how would you define a key rate?

A key rate is an interest rate set by a central bank. This rate applies to loans that the central bank grants to commercial banks. The key rate has an influence on the interest rate at which these banking institutions then lend money to clients and investors, whether households or companies. But it doesn’t only affect loans – it also has an impact on deposits.

What are the main types of key rates?

In the euro zone, there are three key rates. Firstly, there is the deposit facility rate. In other words, if commercial banks have excess liquidity, they can deposit it with the ECB to earn a return based on this interest rate.

Next there is the refinancing rate which is the rate at which banks borrow money from their central bank for a week, in exchange for securities placed as collateral.

Lastly, there is the marginal lending facility rate applied by the central bank when a commercial bank needs short-term (overnight) liquidity. This represents a safety system for the commercial banks as it guarantees them liquidity in all circumstances, at a rate that is slightly higher than the refinancing rate.

In the euro zone, there are three separate key rates: the deposit facility rate, the refinancing rate and the marginal lending facility rate.

What role do these key rates play in the economy?

We can compare the money to water, and the key rates to a tap which controls the amount flowing through the real economy. Key rates are actually a monetary policy instrument that aims to regulate the economy by encouraging or discouraging households and investors to borrow from or save with the banks. They therefore make it possible to control money creation, whilst also bringing a significant influence to bear on the consumption of economic players and therefore on inflation.

How are they set and by whom? What is the basis for decisions?

Key rates depend on the economic targets set by central banks. In general, there are two sides to this: maintaining economic activity and containing inflation. However, in Europe, the ECB has a single target – to ensure price stability, i.e. to safeguard the value of the euro.

In the euro zone, the ECB is responsible for implementing monetary policy and sets its rates every six months after a meeting that brings together central bankers from the various member countries. At these meetings, a decision is taken on whether to change rates based on forecasts for developments in the economy and inflation.

After 2008, key rates remained at a particularly low or even negative rate over a long period, in order to support the economy that was suffering in the wake of successive crises (banking crisis, euro crisis, etc.). Then from the second half of 2022 there was a sharp rise in rates. We have already seen cycles of rising rates in the past, when the economy was overheating and inflation increasing. Such cycles have been a recurring feature of the last 30 years.

2022-2023 is the first time since the adoption of the euro that we have seen such a rapid succession of rates hikes.

However, 2022-2023 is the first time since the adoption of the euro that we have seen such a rapid succession of rates hikes. They reflect the inflation that we have seen, driven by supply chain issues and soaring raw materials and energy prices following the COVID-19 crisis and the war in Ukraine. In September 2023, we hit a record high of rates of 4%.

What are the impacts of changes in key rates?

The aim is to manage the economy in line with central bank targets. When the central bank decides to raise key rates, commercial banks will be more inclined to deposit their money and to lend less. In principle, an increase in interest rates results in lower borrowing and rising savings, and therefore in a fall in consumption and investment. This reduction in investment usually results in a slowdown in the economy which brings an end to price rises.

On the contrary, low key rates encourage banks to lend more to their clients rather than depositing their liquidity. The drop in the cost of money boosts borrowing and consumption. This increase in demand of course pushes up economic activity and prices.

In 2022 and 2023, we witnessed a sharp rise in inflation due to fears of raw material shortages. This resulted in central banks raising their key rates in order to slow the economy and put an end to price rises or even bring prices down.

What are the current targets of the ECB?

With regard to its monetary policy, the ECB’s current challenge is to keep inflation at around 2% (in May 2024 it was running at 2.6%). To achieve this goal, the ECB chose to raise its key rates. The impact of this hike has yet to be seen as there is a lag of 18 – 24 months from implementation of the policy to its impact. It always takes some time for investment and consumption habits to adapt to new financial conditions.

As inflation is moving towards the 2% target, central banks can start to think about lowering rates, always with a view to keeping inflation in check without putting too much of a dampener on the economy. The ECB made its first cut of 0.25% on 6 June 2024. However, we should bear in mind that we are very unlikely to return to the particularly low rates seen in the past.

However, we should bear in mind that we are very unlikely to return to the particularly low rates seen in the past.