The ECB has cut interest rates. Why did it do so and what does it mean for you?

Prices are no longer rising so fast, and inflation is on track to return to the 2% target. As a result, the ECB Governing Council recently cut interest rates, after keeping them at high levels for nine months.

Why did the ECB cut interest rates?

The ECB is the central bank for the euro, and its mandate is to keep prices stable. When inflation was too high – that is, when prices in the economy were rising too fast – the ECB increased interest rates to help bring it back down. This period of ECB rate hikes began in July 2022 and continued until September 2023.

The ECB’s goal is to keep inflation at 2% over the medium term. Now that inflation is coming closer to that target, the ECB no longer considers it necessary to keep interest rates quite so high.

However, the ECB does intend to keep rates at levels that it considers restrictive enough to 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.

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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 its 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. It does not set the interest rates that you pay on your loans or receive on your deposit. But we do influence them. 

The ECB sets what we call the key interest rates or “policy rates”. These are the rates that the ECB offers to banks that want to borrow from it and for the electronic money those banks might choose to deposit at the ECB overnight.

When the ECB changes its key interest rates, this 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, the ECB can raise its rates to make credit more expensive. This will cool the economy, reduce inflation expectations, and bring inflation down.

If inflation is too low, the ECB 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

The ECB’s interest rate hikes helped to bring inflation back down by cooling demand and sending the message that it is determined to ensure inflation returns to the 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. The ECB has said that it will not allow that to happen.

By adjusting interest rates when inflation is too high or too low, the ECB seeks to give businesses, workers and investors confidence that inflation will meet its 2% target 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 the ECB felt that it could safely cut interest rates at this time.