The tedious subject of base interest rates – The ECB and its financial policy

In the middle of June, the European Central Bank announced that it would leave the base interest rate in the Euro zone at the record low of 0.0 %. There is no change in sight before the summer of 2019.¹ With this relaxed financial policy, the ECB Council around President Mario Draghi wants to stimulate inflation in the Euro zone since 2016. But wait a minute – didn't they always teach you at school that inflation is bad?

Inflation means that on average all prices for goods increase. At first that sounds like a bad deal since one Euro is worth less then.² But inflation can also stimulate economic growth. When it is expected that prices will continue to increase, businesses prefer to invest their money immediately. This increases sales and creates jobs. At the same time labor unions demand higher wages in order to compensate for the devaluation of the Euro. Both lead to increased consumption, prices continue to increase, and businesses achieve even higher sales. An upward spiral of growth is created – at least in theory. So a certain level of inflation is good for the economy. The role of the ECB is to preserve price stability and prevent hyperinflation.³ This is when the price level increases very rapidly, like for instance after WW1 in Germany. At that time prices increased so quickly that people exchanged bundles of money instead of individual bills and transported their bank notes in wheelbarrows. A new currency was therefore introduced in 1923.⁴

The tools of the ECB

In order to achieve the desired moderate price increase, the ECB has a few instruments at its disposal. The most important is the so-called base interest rate. When banks borrow money from the ECB, they have to repay it at the base interest rate. Since the rate is currently 0.0 %, banks basically get the money for free. In turn, they pass on these favorable conditions to their customers. It is for this reason that loans for cars, real estate, or other commodities can be financed at very low interest rates at the moment. Consumers and companies are therefore keen to take up loans and spend more money. When more money is being spent, demand increases and thus in turn prices. Another incentive for banks to offer cheap loans is the "rate of the deposit facility". This unwieldy term is also named “the penalty rate of the ECB" and currently lies at a high 0.4 %. Banks are obligated to deposit money they have not spent or loaned on a business day overnight at the ECB. For this they have to pay a penalty rate. So it is better for banks not to have too much money left over at the end of the day, apart from the needed securities.   

A double-edged sword

The low base interest rate also has its drawbacks. On one hand it is almost not worth putting your money in a savings account. Since banks receive cheap money from the ECB, they are not dependent on the savings of their customers. For this reason, savings accounts earn hardly any interest. At the same time inflation means that saved money will be worth less in the long term. That makes sense. After all, the ECB wants us to spend our money to stimulate the economy. In addition, the combination of low base interest rates and high penalty rates leads banks to grant a lot of credits in order to earn money. This bears the risk of a speculation bubble as was the case 10 years ago in the US. Banks were selling real estate mortgages, hoping that the prices for homes and apartments would continue to increase. However, variable interest rates and insufficient background checks led to many customers defaulting on their loans. Homes were foreclosed, real estate values decreased, and the bubble burst. Some experts are already warning against a repeat of these practices in the Euro zone.

What does the future hold?

The inflation rate of the European Union currently lies in the target range of the ECB and the employment statistics indicate that the ECB will soon normalize its financial policies. The ongoing debt of a few Euro states and impending trade conflicts with the US do give some cause for concern.⁵ As expected, the ECB thus announced that they would not increase the base interest rate before summer 2019.

^{1 ecb.europa.eu
2 ecb.europa.eu
3 investorenausbildung.de
4 planet-wissen.de
5 welt.de}