The European Central Bank (ECB) is expected to raise interest rates for the first time in 11 years at the end of July. The bank does this, among other things, to fight against inflation. But why is this happening? And why do higher interest rates generally lead to lower inflation?
Many European countries are experiencing the highest inflation in years. This is also the case in the Netherlands. Last month, life was 11.2% more expensive than exactly a year earlier. In other European countries, inflation is sometimes even higher. Last month, Estonia had an inflation rate of 19.1% and in Lithuania it was 16.6%.
This inflation came after the corona crisis, when major supply problems arose around the world. The post-lockdown economic recovery also played a role in many countries. When war broke out in Ukraine, inflation rose again.
For a long time, the ECB was not in favor of an increase in the European key rate. The bank said high inflation had nothing to do with monetary policy in Europe. Only the above factors would affect inflation.
That will probably change this summer. The key rate, which is now at -0.5%, will probably be raised to 0% in two stages.
Slow down the economy
The bank does this because a higher interest rate affects the amount of money consumers spend. Normal banks use the policy rate to determine the interest they charge their customers.
A higher interest rate makes it more expensive to borrow money. As a result, people borrow less money. Moreover, with a higher interest rate, people also save more.
Because of these two factors, people spend less money. As a result, the economy slows down.
When the economy slows down, the general price of goods and services goes down. As demand drops, prices also drop. And as soon as prices go down, the inflation rate also goes down. This principle also works the other way around.
A little inflation is good for the economy
The ECB aims to keep inflation at 2%. To achieve this, the bank can therefore increase or decrease the interest rate.
The bank chose this percentage because it believes that a little inflation is good for the economy. The gradual rise in prices encourages consumers to spend their money.
Choosing 2% also ensures that deflation (the opposite of inflation) occurs less quickly. If prices fall, inflation will not immediately fall below zero. The 2% therefore acts as a safety margin.