We have cut interest rates. Why did we do it and what does that mean for you?
6 June 2024
Prices are no longer rising so fast, and inflation is on track to return to our 2% target. As a result, our Governing Council recently cut interest rates, after keeping them at high levels for nine months.
Why did we cut interest rates?
We are the central bank for the euro, and our mandate is to keep prices stable. When inflation was too high– that is, when prices in our economy were rising too fast – we increased interest rates to help bring it back down. We started raising rates in July 2022 and kept doing so until September 2023.
Our goal is to keep inflation at 2% over the medium term. Now that inflation is coming closer to that target, we no longer need to keep interest rates quite so high.
We will, however, keep rates at levels which ensure that inflation returns to 2% in due course and doesn’t become “stuck” at a higher level. This is very important, as high inflation makes life hard for people and businesses.
What are interest rates?
Interest rates are the cost of borrowing money (it is sometimes said that interest rates are “the price of money”). For example, to take out a loan from a bank, you first have to agree on the interest you will pay, which is usually shown as an annual rate. Let’s say you borrow €10,000 at an annual rate of 5%. This means you will have to pay your bank €500 per year in addition to paying back the loan. So, the interest rate is essentially what the bank charges you for lending you money.
But 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 a savings account with an annual rate of 3%, at the end of the year you will receive €30 in interest.
What causes interest rates to move?
The interest rates that banks offer people and businesses are strongly influenced by the rates set by the ECB. So when the ECB changes interest rates, the interest rates on loans and savings usually move broadly in the same way.
But borrowing and saving rates are also affected by the demand for and supply of credit: in other words, how much businesses and people want to spend, invest, and how much credit is available.
Markets for other goods and services work in a similar way. For example, if many people want to buy strawberries, but there aren’t many available (because it is not the season), their price goes up.
Likewise: when businesses and people want to spend and invest, but can’t easily get enough credit to do so, interest rates tend to go up. Borrowing money becomes more expensive. Conversely, when people and companies are saving a lot of money in the bank, then interest rates tend to go down.
The ECB is the central bank for the euro. We do not set the interest rates that you pay on your loan or receive on your deposit. But we do influence them.
We set what we call the key interest rates or “policy rates”. These are the rates we offer banks that want to borrow from us and for the electronic money they keep with us overnight.
When we change our key interest rates, it affects the entire economy, including the rates for mortgages, bank loans, or bank deposits.
The ECB’s Governing Council takes decisions on these key interest rates roughly every six weeks.
How do the key ECB interest rates affect inflation?
If inflation is too high, we can raise rates to make credit more expensive. This will cool the economy, reduce inflation expectations and bring inflation down.
If inflation is too low, we can lower interest rates and make credit cheaper to boost investment and spending, which raises inflation.
In recent years, inflation was too high. Prices increased a lot, especially for energy and food. One reason for that was Russia’s invasion of Ukraine. Another was that many companies found it more difficult to get the materials, spare parts and workers needed for production, which worsened existing problems caused by the pandemic.
Using interest rates decisively also keeps inflation expectations under control
Our interest rate hikes helped to bring inflation back down by cooling demand and sending the message that we are determined to ensure inflation returns to our 2% target.
It is important for central banks to keep a close eye on how much people and businesses think prices will rise in the future – in other words, inflation expectations. If people believe that high inflation will last, they are more likely ask for higher wages, and companies might in turn increase prices to protect their profits. In this way, high inflation expectations can lead to a spiral of rising prices and wages. We will not allow that to happen.
By adjusting interest rates when inflation is too high or too low, we give businesses, workers and investors confidence that inflation will be at our 2% over the medium term. This commitment – backed up by action – helps anchor expectations that price stability will be maintained. It is also a reason why we can safely cut interest rates now.