Never before has the ECB raised interest rates as much as it is today. It is questionable whether the monetary watchdogs will be able to curb record inflation quickly. Consumers will still feel the consequences clearly.
It is a historic decision: the European Central Bank (ECB) has increased the key interest rate for the euro area by 0.75 percentage points. There has never been such a “jumbo step” since the introduction of euro cash in 2002. “We had different views around the table, a thorough discussion, but the result of our discussions was a unanimous decision,” President Christine Lagarde said at the press conference in Frankfurt today.
The second tightening of monetary policy within a few weeks had been expected. As early as July, the monetary watchdogs had raised interest rates for the first time since 2011, thereby turning away from their long-standing zero interest rate policy. How are the prices going now? And what changes does this bring to everyday life?
Lending rates are likely to rise further
“The interest rate hike will be felt in a relatively short time for consumers who want to take out a loan to buy a house, for example,” says Emanuel Mönch, professor of monetary policy and financial markets at the Frankfurt School of Finance & Management, in an interview with CityRyde.com. Because the lending rates for real estate and companies, in particular, would move relatively quickly with the key interest rates.
Above all, the so-called main refinancing facility and the top lending rate play a role in which commercial banks can get fresh money from the ECB. According to today’s decision in the eurozone, the main refinancing rate, which applies to maturities of one week or more, is 1.25 percent and thus higher than it has been for more than ten years. As a result, the costs for financial institutions to raise money are climbing. The result: loans for households and companies are also becoming more expensive. As a rule, the banks pass on the increased costs directly to consumers and companies in the form of higher interest rates.
The real estate industry expects soon with more expensive financing for buyers due to the sharp increase in key interest rates. “As a result, interest rates for real estate loans will probably continue to rise, and the pressure on the residential real estate market will increase again,” said Oliver Wittke, general manager of the Central Real Estate Committee (ZIA). After the ECB decision, the credit broker Interhyp is also assuming “further slight increases in construction interest rates” in the coming months, according to Mirjam Mohr, a board member for private customer business. “By the end of the year, we expect interest rates to be around 3.5 percent on ten-year loans.” Interest rates have already climbed from 2.7 percent in August to around 3.2 percent at the moment.
Only a pseudo effect for savers
“The higher interest rates are only one side of the coin,” explains Christina Bannier, Professor of Banking & Finance at the Justus Liebig University in Giessen. On the other hand, the question arises as to whether interested parties can still get a loan at all. “When a bank receives an inquiry, it examines the potential borrower very thoroughly and thinks about whether they can afford the more expensive interest and principal payments in the future,” the expert told CityRyde. There is also the risk of a recession, which can mean job losses and a drop in income. Lending could therefore become much stricter – especially for long-term real estate loans.
The third key interest rate, which was also increased by 0.75 percentage points to 0.75 percent in the future, is the so-called deposit facility. This is the rate at which banks overnight deposits with the ECB earn interest. After years of penalty interest, they can earn money again in the future if they park excess liquidity at the central bank. This is also good news for savers because financial institutions have passed on the negative interest rate to their customers in the form of a custody fee in recent years. As a result, many had to pay interest to their bank on their checking account balances and, in return, received almost nothing in return for their savings accounts. This is now over – if not immediately.
The banks reacted “always with a bit of a wait until they pass on the rising interest rates to their customers,” says Bannier. Nevertheless, it will “definitely come.” In the future, savers can expect rising interest rates for the money market or time deposit accounts. The economist warns, however, that one should not be fooled by this: “The effect is only apparent for the time being since we are currently experiencing incredibly high inflation. It is currently completely eating away at the additional purchasing power from the money saved.” For a really noticeable effect, the interest on the savings accounts would have to rise much more, or inflation would have to fall more sharply.
Differences between theory and practice
The ECB is now aiming for the latter with its unprecedented move. Mainly because of the expensive energy as a result of the Ukraine war, inflation in the eurozone has now reached a record level of 9.1 percent. The inflation is more than four times as high as the stability target of two percent per year. Economic theory says that higher interest rates make it more expensive for companies to invest. They also weaken private consumption through more expensive loans. Consumers will be tempted to save more money instead of spending it. Companies, on the other hand, are left with their goods.
The desired result: falling prices. But how realistic is that? “I believe that this rate hike was absolutely necessary. At the same time, however, I believe that it will not be enough to curb inflation significantly,” says expert Mönch. A large part of the inflation is due to supply chain bottlenecks and higher energy prices. “These are developments that the central bank’s interest rate policy cannot really influence.” Nevertheless, the increase in interest rates is contributing to a weakening of the economy, which is curbing demand and ultimately also alleviating the high prices a little.
Economist Bannier sees it similarly and points to a lack of experience with the current situation: “So far, the central bank has tried to influence demand-side problems. However, the current difficulties in Europe are on the supply side and are also very complex: the Ukraine war, the Energy crisis, food problems, aftermath of the Corona crisis, and an extremely high national debt.” It is, therefore, difficult to predict how the higher interest rates will actually affect him.
The ECB has announced that it will raise interest rates to a level that will allow inflation to return to target soon. The central bank raised its inflation forecasts for the current year to 8.1 percent in view of the ongoing surge in prices for energy, food, and other goods. In 2023, however, inflation is expected to be only 5.5 percent.
Expert Mönch disagrees: “I believe that inflation will initially increase. My assumption is that energy prices will not fall in the short term, but rather continue to rise.” In addition, the unions have high demands in collective bargaining, so rising wages could further fuel inflation. “In the short term, I don’t see any developments that could lead to sharp declines. The dampening of demand through higher interest rates will make a contribution – but more slowly than faster.”
“Right now, it’s extremely difficult to give a forecast,” says Bannier. There is also another negative consequence: “Higher interest rates also mean more expensive loans for the state. Refinancing will become more difficult.” In combination with a weakening economy, this means “sooner or later tax increases in order to be able to handle the national debt.” Another cost that consumers in the euro area will have to adjust to in the future – in addition to higher interest rates.