Interest rates have a big impact on our economy. How much can you earn on your savings? Can that business still finance the new machinery it needs? This is why it's important to understand what – and who – sets interest rates.
Interest is a fee for lending money. When you take out a loan from the bank to buy a house, you pay mortgage interest. And when a business purchases a new machine with a bank loan, it pays borrowing interest.
It also works the other way round: if you have a savings account, your bank pays you interest on your savings. You are lending your money to the bank, after all.
Interest is also known as the cost of money.
The market
It is the market that primarily determines how high or low interest rates are. More precisely, interest rates depend on the supply and demand for loans and savings. If savings are in great supply or if there is little demand for loans, interest rates are low. And if demand for loans increases, interest rates go up.
Interest rates, the cost of credit, move according to the law of supply and demand just like the cost of any other product. Take cardboard, for example. Demand has increased because we are doing more and more shopping online, and all those purchases are packed in cardboard for shipping. At the same time, supply has decreased due to the scarcity of paper. The result: the price of cardboard went up.
Central banks
Apart from the market, central banks also influence interest rates. In the euro area, the European Central Bank (ECB) does so by setting what is known as the key policy rate. This interest rate determines the fee commercial banks pay when they borrow money from the ECB or from the central banks of euro area countries (this is called the refinancing rate). The key policy rate also determines the interest rate banks receive when they "deposit" money with the central bank (known as the deposit facility rate). The same key policy rate applies in all countries that use the euro, including the Netherlands.
Only banks are directly affected by the key policy rate, but its level also ultimately affects the interest rates paid by consumers and businesses. So the interest rate set by the ECB affects the savings rate you get, how "expensive" your mortgage is or the interest charges a business pays for a loan.
Generally, you pay a lot more interest than the key policy rate set by the ECB. With a mortgage, for example, the bank incorporates its costs into the interest rate and, of course, it wants to make some profit on the loan. The bank also charges a little extra in the form of a risk premium in case something goes wrong during the term and you can no longer repay the loan.
Development of interest rates and inflation and factors affecting both
© DNB
Low interest rates until 2022
Interest rates in the years prior to 2022 were unusually low. For a while, banks paid little or no interest on savings; you even had to pay interest to your bank if you had a lot of money in your savings account.
The low interest rates were great for people and businesses looking to borrow money: mortgage rates, for example, were historically low. This meant that a homebuyer could borrow a larger amount at the same monthly cost.
The government could also borrow money cheaply to cover budget deficits. Pension funds, however, were not so lucky. The low interest rates meant that they had to set aside more money to secure pensions for the future.
Why were interest rates so low? Savings are in great supply worldwide. This is partly due to an ageing population: older people tend to spend less and save a lot. Demand for business loans was also relatively low. The service sector grew, but companies in this sector invest less than in manufacturing, which needs factories and machinery.
And on top of all this, central banks kept their key policy rates low. This is because inflation was low in the years prior to 2022. Too low, according to the monetary policy of the European Central Bank (ECB). The ECB's policy calls for a medium-term inflation target of 2%. The ECB therefore kept key policy rates low in recent years to boost inflation towards the target.
This meant it was "cheap" to borrow money, allowing more money to circulate. And a bigger supply of money drives up inflation.
Interest rates rising since 2022
A lot has changed since then: interest rates are rising again. If you have money in savings, you have probably heard from your bank that you are once again earning interest. Earning interest on savings is great, of course, but people looking to take out a new mortgage on a house will also notice that interest rates are a lot higher than in 2021. Higher interest rates make mortgages more expensive.
They also affect businesses, which have to spend more money to take out a loan. The government also faces higher interest charges on its loans. Pension funds, on the other hand, benefit from higher interest rates, which make it easier for them to continue paying pension benefits in the future.
That upswing in interest rates is again due both to the situation in financial markets and, above all, central bank policies.
In June, September, October and December 2024, the ECB decided to lower its interest rate by 0.25%. Previously, the central bank had raised its rate to 4% in 10 steps, starting in July 2022. The aim was to cool the economy in order to bring down the soaring inflation rate. Prices had skyrocketed in the wake of the pandemic and the Russian invasion of Ukraine, and inflation was far above the ECB’s medium-term target of 2%. With this rate cut, the ECB is gently taking its foot off the brake, which will help boost economic growth.
Higher interest rates make money “more expensive”, making it less attractive to borrow and spend money, and encouraging saving instead. As a result, people and businesses spend less, causing the economy to slow down. And when demand slumps, prices stop rising. That way, the interest rate helps get inflation back to ideal levels. With inflation falling and expected to return to the 2% target soon, the ECB may decide to lower its interest rate again. Interest rate cuts do not have an immediate effect on prices and inflation, however. This takes some time.
Loan supply and demand and savings in financial markets also affect interest rates, and meanwhile the market is trying to predict economic growth and inflation, especially when it comes to long-term loans. What interest rate steps will central banks take next?
As soon as there is reason to readjust the key policy rate, the ECB will do so. Because as the central bank for the euro area, its mission is to keep prices stable.
If you take time to study the subject of interest, you will come across different concepts and types of interest. We list the most important ones below.
Short-term interest rate or money market rate
The interest rate in the money market on a short-term loan: a loan with a term of up to one year. The shortest term is one day. This overnight interest rate is close to the ECB's key policy rate.
Long-term interest rate or capital market rate
Interest on a long-term loan with a term of more than one year, for example a 10-year bond loan. The long-term interest rate is usually higher than the short-term one, but not always. When it is not, we speak of an 'inverted yield curve'.
When setting long-term interest rates, market participants mainly look ahead: what will central banks do with interest rates down the road? What will happen to inflation and economic growth?
Real and nominal interest rates
In times of high inflation, real interest rates are key. When you lend money, you get paid interest for it, but inflation makes the money worth less. To determine the net effect, we use the concept of real interest rates. You roughly calculate this rate by subtracting the expected inflation rate from the agreed interest rate on the loan, also known as the nominal interest rate.
Key policy rate
The key policy rate or official rate is the rate set by the ECB for its own transactions with commercial banks. The key policy rate determines the fee commercial banks pay when they borrow money from the ECB or central banks in euro area countries (the refinancing rate). The key policy rate also determines the interest rate banks receive when they "deposit" money with the central bank (the deposit facility rate).
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