What is the key interest rate?

What is the key interest rate?
What is the key interest rate?
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The key interest rate of the European Central Bank (ECB) is currently at 1.25%. Savings account interest rates are significantly below this rate, and if someone takes out a loan, they usually have to pay significantly more than this (base) rate. In this article we discuss the role of the key interest rate and which interest rates are relevant.

What role does the ECB’s key interest rate play?

Key interest rates particularly influence the interest rate environment at the short end, the so-called money market, and thus maturities of up to a maximum of 1Y. This means that the central banks control the interest rate level at the short end with their interest rate policy. For example, the interest rates (“yields”) on German government bonds, which have long yielded a negative return, have turned positive as a result of the central bank’s recent interest rate hikes.

Source: Refinitiv Reuters, as of 14 September 2022; Yield of German government bonds

The interest rates (also referred to as yields) of long maturities are formed on the capital market. When calculating yields, the current daily prices of, for example, government bonds and the interest payments on these bonds (coupons) are taken into account. Therefore, the interest payments (coupons) on bonds differ from the yields, since the prices and thus the yields of bonds change daily, even second-by-second, in line with the new interest rate expectations of the market participants.

The market participants analyze which interest rate decisions are to be expected from the central bank and act accordingly. They are mainly guided by the inflation trend and the economic picture. In recent years, the central banks themselves have also acted as market participants in longer-dated bonds by buying government and corporate bonds. This is part of the monetary policy instruments that a central bank has at its disposal.

So, what is THE key interest rate?

Strictly speaking, there are several key interest rates of the ECB. As a rule, the key interest rate is the interest rate at which commercial banks can borrow money from the ECB. This interest rate is also called the main refinancing rate.

Oesterreichische Nationalbank defines the key interest rate as follows: short-term interest rate whose change influences other interest rates. The term “key interest rate” primarily refers to interest rates that can be set by a central bank as part of its monetary policy measures.

What are the European Central Bank’s interest rates?

ECB interest rateExplanationCurrent level
(as of 12 September 2022)
Deposit rateInterest rate at which commercial banks
can deposit their money with the ECB
at very short notice (overnight)
0.75%
Main refinancing rate
(key interest rate)
Interest rate at which commercial banks
can borrow money from the ECB for one week
1.25%
Marginal rateInterest rate at which commercial banks
can borrow money from the ECB
at short notice (“overnight”)
1.50%

How does the key interest rate affect savings account interest rates?

If the central bank raises the key interest rate, the interest rate on money that is newly saved, such as on a savings account, normally also increases. The key interest rate thus influences savings account interest rates.

Background: The key interest rate affects the so-called deposit rate. At this interest rate, banking institutions can deposit funds with the central bank at very short notice (overnight). Savers can orientate themselves on this deposit rate, which is significantly lower than the key interest rate, or main financing rate.

ECB: key interest rate and deposit rate (-15Y)

Source: Refinitiv Datastream (14 September 2007 – 15 September 2022); Note: Past performance is not a reliable indicator of the future performance of an investment.

What drives the level of interest rates on savings books?

The basis is the deposit interest rate that the European Central Bank sets for the commercial banks. In addition, the interest rate on savings books depends on whether a commitment period has been agreed or whether the amount can be withdrawn daily. Furthermore, the rating of the bank and of the customer and competition play a role.

Worth knowing: There can be no negative interest rates on savings books. However, this is no longer an issue anyway, now that the ECB has raised interest rates. There is also a protective shield for savings books: the deposit guarantee scheme protects the savers. Savings and current account deposits are protected for up to EUR 100,000 per customer and bank.

How does the key interest rate affect the interest rate on loans?

The key interest rate affects the interest rate on loans via the refinancing rate if you have taken out a variable-rate loan. A variable-rate loan is based on the interest rates at the short end, for example the three-month money market rate. This money market rate fluctuates around the key interest rate, or refinancing rate. If you have a fixed-rate loan, the key interest rate does not affect it.

Conclusion

The most important key interest rate of the European Central Bank is the main refinancing rate. If this rate rises, it means that credit institutions are incurring higher costs for borrowing money from the central bank. Credit institutions take interest rates and their changes into account when concluding new contracts. Due to competition, banks react to different degrees and at different speeds. For savers, rising key interest rates mean that they can expect a higher interest rate for new funds.

For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management

Legal note:
Prognoses are no reliable indicator for future performance.

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