European Central Bank cuts lending interest rates: What will it change?

26, Jun - NEWS

In July 2022, the European Central Bank decided to raise interest rates sharply. This marked a turning point for the institution in charge of monetary policy in the European Union, which at the time had not decided to raise rates for 11 years, beginning a series of ten rate hikes until last September.

The ECB's key interest rates are the main monetary policy tool in the eurozone, setting the lending rate for commercial banks. As a consequence, its interest also affects the rate at which those same banks lend to households and businesses. At a press conference on Thursday, June 6, ECB President Christine Lagarde announced the end of the period of rate hikes. Rates will fall by 25 basis points, from 4% to 3.75%. This will happen for the first time since 2019.

Reasons behind that decision

By raising interest rates in 2022, the ECB hoped to cope with the sharp rise in inflation caused by the COVID-19 crisis and the outbreak of war in Ukraine, among other things.

"In periods of inflation, i.e. when prices rise because supply exceeds demand, raising the key rate acts as a regulatory tool. It leads to a reduction in lending and hence a reduction in the money supply circulating in the economy. Household demand falls and the gap between supply and demand shrinks," explained economist Sylvie Matelli, director of the Jacques Delors Institute, in a previous interview with Public Sénat.

The decision to raise the key rate came as inflation reached over 8%, followed by a record 10.6% in October 2022. Today, however, inflation has returned to near the threshold level set by the central bank. It stood at 2.7% last April, and despite a small rise of 0.2 points in May, the ECB decided to ease pressure.

What are the implications for governments, businesses and households?

A key rate cut could have direct implications for borrowers - both households and businesses. By borrowing less from the ECB, banks will be able to lower interest rates and relax credit conditions for their customers. This is demonstrated by the fact that in recent years, increases in key interest rates have led to a sharp rise in the cost of credit across Europe. For example, in France, the average rate on real estate loans rose from just over 1% at the start of 2022 to over 4% two years later.

The ECB's decision is also good news for governments tackling high public debt, as lowering the key rate means easier conditions for government borrowing. On the other hand, it could be bad news for savers, as the rate of return on deposits is also determined by the ECB's key rates. Thus, returns to savers could fall.

Is the ECB planning another rate cut in the coming months?

Despite the relative improvement of the economic situation in Europe, it is almost impossible to predict further key rate cuts. In May, inflation rose slightly compared to the previous month and amounted to 2.6%. According to the most optimistic ECB directors, a decision on further rate cuts could be made as early as this summer.

After the war in Ukraine, the situation in the Middle East poses a risk of prolonged inflation. Since the beginning of the conflict between Israel and Hamas, the increasing attacks on ships off the coast of Yemen tripled the cost of maritime transportation, which affected the prices of goods imported to Europe.