The Russian invasion of Ukraine has caused an economic crisis throughout Europe. As a consequence, inflation has skyrocketed and the prices of products and services in the market are reaching historic levels. In Europe, inflation reached 9.6% year-on-year in the month of June, which means that products are 9% more expensive than at the same time a year ago.
Added to this is the Russian gas energy crisis, which has created a scenario of uncertainty for companies and governments. At the moment, Russia maintains the supply through the Nord Stream 1 gas pipeline, one of the most important in Europe. However, doubts remain about whether Russian President Vladimir Putin will use the gas to put pressure on eurozone countries.
Faced with this situation, European countries are suffering the consequences in their economies. To avoid worse conditions from the economic point of view, the European Central Bank (ECB) has taken an important decision: it has raised the reference interest rates to 0.50%.
What are interest rates and how do they work? What consequences does the ECB’s decision have for the economy? We explain it to you below.
Why are interest rates going up?
One of the most important objectives of the European Central Bank is to control the stability of prices in the eurozone, trying to keep inflation from exceeding 2%. To achieve this economic stability, the ECB can use different mechanisms and, among them, are interest rate increases.
Interest rates are defined as the amount that must be paid to use an amount of money in a given time. In this case, the ECB rates refer to the rate that banks must pay more to obtain loans from this European institution.
Let’s take an example. If the ECB lends one thousand euros to the Bank of Spain and interest rates are at 0.50%, Spain will have to repay the ECB the borrowed money plus 0.50% interest. In this case, the Bank of Spain would have to return 105 euros in interest.
The European Central Bank can use different mechanisms to stabilize the rise in prices.
But what is the relationship between interest rates and inflation? Interest rates set how much money is worth in the markets. In times of inflation like the current one, prices rise and the value of money falls (as has happened with the euro in recent weeks). For this reason, the Central Banks decide to raise interest rates: a rise in rates makes money more expensive and more valuable.
If the price of money is more expensive, the loans made by banks will also be more expensive and people who take out a loan will have to pay more money. The ultimate goal is for people to ask for fewer loans (because they are more expensive): if there is less private spending, the rise in prices will moderate and, therefore, inflation will stabilize.
Consequences of the rise
As we have explained, the rise in interest rates will have a direct impact on individual loans. The higher the rate rise, the more expensive the loans will be and the more difficulties individuals and companies will have when requesting financing.
In the case of mortgages, for example, their concession will be more expensive and there will be less chance of obtaining a loan of this type. This will have a negative consequence for lenders, who will have a harder time finding people interested in borrowing money.
The rise in interest rates could curb consumption and moderate the sharp rise in prices.
The rise in rates can also directly affect consumption: by not being able to borrow at an affordable price, people will begin to consume less. This can have a negative consequence in the market and in many businesses, which will see their sales decrease.
The rise in interest rates will affect people with fewer resources more, who will not be able to continue spending as before. This will affect the price of basic products, such as food or energy. In the long term, it will help to lower the price of Russian energy or Ukrainian grain, which have become extremely expensive because of the war. However, it will have a great social cost.
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