Interest rates: what you need to know
We’ve already discussed on this blog the importance of interest rates and their effect on investments. Now, we want to explain a bit more about how they work and what it means when the European Central Bank—or the Fed—raises or lowers interest rates.
What are interest rates?
As the Bank of Spain explains, “an interest rate is a percentage that expresses the cost or yield of a loan or certain savings instruments.” When we borrow money from a bank, the interest rate is the “extra” money we have to pay for borrowing it. Conversely, when we lend money to the bank—by putting it in a savings account—the interest rate is what the bank pays us.
Interest rates make sense because they are a way to compensate for risk. For example, if I lend money, it’s reasonable to ask for interest because the future is uncertain, and the borrower might not be able to pay me back.
Moreover, interest rates influence the economy in several ways. As the European Central Bank (ECB) explains, the economy “functions better when prices remain generally stable, as money retains its value, and people and businesses can better plan their spending and investments.” When interest rates are low, borrowing money is cheaper, which can stimulate consumption and investment. On the other hand, when interest rates are high, borrowing becomes more expensive, which can slow down consumption and investment.
That’s why monetary policy, which aims to keep prices stable—i.e., to keep inflation under control—uses interest rates as its main tool. In most cases, interest rate decisions are delegated to independent bodies: central banks. In the case of Spain—and the rest of the eurozone—the institution making those decisions is the ECB.
Nominal vs. real interest rate
There are many types of interest rates, from simple and compound interest to APR. Here we’ll focus on a fundamental distinction: nominal vs. real interest rates.
The nominal interest rate is the percentage of interest paid on a loan or received on a deposit without considering inflation. It’s the interest rate we typically see in loan contracts or savings accounts. For example, if you have a loan with a 5% interest rate, that’s the nominal interest rate.
The real interest rate is so named because it more accurately reflects reality. Why? The real interest rate takes inflation into account, or in other words, the purchasing power of borrowers and savers. Only by considering inflation can you know the actual cost of a loan or the real return on a savings account. It’s calculated like this:
Real interest rate = nominal interest rate – inflation
ECB interest rates
As mentioned, interest rates are the main lever of monetary policy. In Europe, the decision-maker is the ECB, and more specifically, its Governing Council. This body meets twice a month to assess the economic and monetary situation and make decisions. The last time, on July 18, it decided to maintain interest rates. In the previous meeting, on June 6, it cut rates by 25 basis points.
What rates are those? The ECB sets the so-called “policy rates,” which are the interest rates offered to banks that want to borrow money from the ECB and the rates paid to banks that deposit electronic money with the ECB. These are:
The main refinancing operations rate: this is the interest rate banks pay when they borrow money from the ECB for a week. In other words, it’s the rate the ECB uses to provide liquidity to banks. It currently stands at 4.25%.
The marginal lending facility rate: this is the rate the ECB charges credit institutions for overnight loans. It is currently 4.50%.
Finally, the deposit facility rate determines the interest banks earn for depositing money with the ECB overnight. It is currently 3.75%.
What impact do ECB interest rates have?
Interest rates have numerous effects on the economy. They affect how banks lend money to their customers, but also influence inflation expectations, asset prices, consumption and investment decisions, and the availability of financing, among other things.
When the ECB decides to raise interest rates, its main goal is to control inflation. By raising interest rates, the ECB makes borrowing more expensive. This means that companies and consumers are less likely to take out loans to spend or invest, which reduces demand in the economy and, in theory, helps cool down inflation.
An increase in interest rates also tends to strengthen the local currency, as international investors seek higher returns in the country. However, this can make exports more expensive and less competitive in the global market.
Conversely, when the ECB lowers interest rates, it aims to stimulate the economy. Borrowing becomes cheaper, which can encourage businesses and consumers to take out loans and spend more. This can increase aggregate demand and help combat unemployment and low economic growth.
A decrease in interest rates also tends to weaken the local currency, which can benefit exports by making them more competitive in the international market.
In summary…
Interest rates are a powerful tool in economic policy, influencing consumption, investment, and overall economic stability. Understanding the difference between nominal and real interest rates is essential for grasping the true cost of money. The ECB plays a crucial role in regulating these rates, adjusting them to control inflation and maintain economic stability. By understanding how interest rates work and the ECB’s influence, individuals and businesses can make more informed and strategic financial decisions.