The Key Lending Rate

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November 2021

The Key Lending Rate

Interest rates come into play everywhere – just think of home loans, fixed income or savings. Their level is modelled on the key lending rate, which is set by the European Central Bank (ECB). This means the ECB has significant influence over the economic situation, the inflation rate and the exchange rate.

How does the key lending rate work?

For one thing, the key lending rate determines the level of interest paid by commercial and private commercial banks that want to borrow money from the ECB – thus acting as the main refinancing rate. Its level is fixed by the ECB’s Governing Council, its top decision-making body. The key lending rate is fixed and announced at scheduled times and in regular intervals. Emergencies take exception to this pattern. Since it is part of the job of central banks to use the key lending rate to prevent major price fluctuations, economic slumps may necessitate interest rate changes out of turn to address a given emergency.

Although the term “key lending rate” is frequently used as if it referred to one rate only, it actually consists of three different key lending rates. Aside from the main refinancing interest rate, there is the marginal lending rate and the deposit rate. The marginal lending rate indicates the interest rate at which a commercial bank may borrow from the ECB if the transaction is supposed to take place overnight. The deposit rate, by contrast, refers to the interest rate at which banks can deposit their money with the ECB. Principally speaking, all three types represent key lending rates. As a rule, however, the term “ECB key lending rate” implies the main refinancing interest rate.

The key lending rate and the economy

The key lending rate is set for the purpose of stabilising the price level by keeping the inflation rate low. After all, as long as interest rates are low, the costs of borrowing remain more affordable for banks. This enables them in turn to lend more freely to businesses. The investment potential is generally stimulated as a result. A collateral effect being that savings deposits pay very little interest on savings. However, since the key lending rate is often used as reference interest rate, e. g. for home loans with variable interest rates, these will rise or fall in sync with key lending rate changes. The idea on the part of the ECB is to encourage people to spend money and thereby to boost the economy. At the same time, the amount of money in circulation increases, which may cause its value to erode and prices to soar quickly. In order to counter this effect, the level of interest rates is raised, so that less money is available to banks and it becomes once again a paying proposition to deposit money in savings accounts.

For now, the ECB is still targeting an inflation rate of two percent. The current rate in Germany is 4.5 percent. It prompted the ECB to leave the key lending rate unchanged at 0.0 percent. The deposit rate was fixed at minus 0.5 percent. Overnight loans are subject to 0.25 percent interest. However, it remains to be seen whether the trend, as assumed by the ESB, will be a limited medium-term phenomenon. The long-term plan behind the measures is in any case to overcome the coronavirus crisis quickly.

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