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Moeder en dochter in de supermarkt

Interest rates

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. 

What is interest?

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.

Who or what sets interest rates?

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

Development in 10-year interest rate and inflation in the seven largest countries (G7) since 1980.

Low interest rates, rising interest rates

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.  

ECB raises key policy rate

In the summer of 2022, the ECB raised the key policy rate for the first time in 11 years. Indeed, prices in the euro area had been rising too fast for some time already. Inflation, initially lower than desired, was suddenly well above the ECB's medium-term target of 2%.

Higher interest rates make money "more expensive" and make it more attractive to save. People and businesses spend less as a result, which slows down the economy. When demand falls, prices drop. This is how higher interest rates help get inflation back to ideal levels.

In financial markets, the supply of savings and demand for loans also affect interest rates. But the market also tries to look ahead, especially when it comes to long-term loans: how will economic growth and inflation develop? What interest rate steps will central banks take next? 

How high will the interest rate go?

It is not easy to say just how high the ECB will raise the key policy rate. After the first rate hike in July 2022, more increases followed, with interest rates remaining unchanged at 4% for the first time in October 2023. Interest rate hikes do not have an immediate effect on prices and inflation. The ECB therefore continuously monitors inflation developments and expectations closely. As soon as there is reason to readjust the key policy rate, it will do so, because the ECB is the central bank for the euro area, and its mission is to keep prices stable.

For the enthusiast: types of interest

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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