Whether it’s home loans, bonds, or savings—interest rates play a role in all of them. The key interest rate serves as the benchmark for these rates. It is set by the European Central Bank (ECB). As a result, the ECB has a significant influence on the economic situation, inflation, and exchange rates.
How does the key interest rate work?
First, the key interest rate determines the interest payments for commercial and credit banks that wish to borrow money from the ECB—this is known as the main refinancing rate. The corresponding interest rate is set by the ECB’s highest decision-making body—the Governing Council. The rate is set and announced at specific times and at regular intervals. Exceptions to this are emergencies. Since it is part of central banks’ mandate to use the key interest rate to protect the price level from excessive fluctuations, emergency—and thus irregular—interest rate changes may also occur during economic downturns.
Although the term “key interest rate” is often used to refer to a specific rate, there are actually three different types of key interest rates. In addition to the main refinancing rate, there is the marginal lending rate and the deposit rate. The marginal lending rate specifies the interest rate at which a commercial bank can obtain a loan from the ECB if the transaction is to take place overnight. The deposit rate, on the other hand, describes the interest rate at which banks can deposit their funds with the ECB. In principle, all three types are key interest rates. As a rule, however, the term “ECB key interest rate” refers to the main refinancing rate.
The Key Interest Rate and the Economy
The key interest rate is set with the goal of stabilizing the price level through a low inflation rate. This is because when interest rates are low, banks are able to obtain loans at more favorable terms. At the same time, more loans can be extended to businesses. Overall, this stimulates investment potential. A side effect: Savers do not receive high interest payments on their savings. However, since the key interest rate is often used as a benchmark—for example, for variable-rate mortgages—these rates rise and fall in tandem with changes in the key interest rate. In this way, the ECB aims to encourage people to spend money and thereby strengthen the economy. At the same time, more money enters circulation, causing it to lose value and allowing prices to rise rapidly. To counteract this process, interest rates are raised, so that banks generally have less money at their disposal and saving becomes more worthwhile again.
The ECB is currently aiming for an inflation rate of two percent. In Germany, the rate currently stands at 4.5 percent. For this reason, the ECB decided to maintain the key interest rate at 0.0 percent. The deposit rate was set at minus 0.5 percent. Overnight loans incur an interest rate of 0.25 percent. However, it remains to be seen whether this trend will persist only in the medium term, as the ECB assumes. In the long term, these measures are intended to facilitate a swift recovery from the COVID-19 crisis.
