Economy

Four questions about... rate hikes

Philippe Ledent

Philippe Ledent

Senior economist

The interest rates of central banks influence, to a greater or lesser extent, the interest rates on loans and deposits. Central banks are raising or will raise their rates. What are the effects of such a decision? Here are 4 questions and answers to help you decipher the situation.

1. Why are we currently talking about rate hikes?

  • Until last year, weak economic growth and especially very low inflation in the eurozone led the European Central Bank (ECB) to keep rates very low. In this way, it tried to stimulate activity and inflation. In 2014, it even decided to push short-term rates into negative territory.
  • But since 2021, inflation has soared, first because of the reopening of the global economy following the favourable evolution of the pandemic, and more recently because of the war in Ukraine. In addition to the currently very high inflation (9% in May in Belgium), inflation expectations for the coming years have risen sharply. This means that households and companies are increasingly expecting higher inflation in the coming years than in the past.
  • The ECB is the guarantor of price stability in the medium term, i.e. moderate inflation in the coming years. Therefore, it should act very soon against the rise in current and anticipated inflation by economic agents. To do so, it should gradually raise its interest rates, and probably put an end to negative rates in September.
  • Indeed, higher rates slow down the demand for credit and economic activity, which should put a brake on the upward pressure on consumer prices and calm inflation expectations.

2. What are the consequences for market interest rates?

  • In anticipation of the ECB's expected moves, long-term rates have already risen. For example, the 10-year rate on Belgian government debt, which was still negative in the summer of 2021, is now close to 1.75%.
  • Short-term rates on the financial markets are also likely to rise very soon, once the ECB has confirmed its own rate hike. This is not a huge move, but it is enough to remove negative rates from the financial markets.
Long rates anticipated future ECB actions

Long rates anticipated future ECB actions

3. How high can rates go?

  • The ECB is caught in a difficult situation.

On the one hand, current and expected inflation requires it to act.

But on the other hand, economic activity has been hit hard by a succession of shocks (pandemic, war in Ukraine, supply difficulties).

  • Therefore, if we do indeed expect the end of negative rates in the financial markets very soon, it is unlikely that the ECB will have the capacity to raise its rates very sharply. Indeed, a too rapid rise in rates would provoke a recession. The level of interest rates should therefore not rise sufficiently to compensate for the current level of inflation. 

4. What to do?

  • Saving? It is often advisable to keep the equivalent of 3 to 6 months of income in cash. The end of negative interest rates makes saving a little more attractive, but this will not compensate for the loss in purchasing power of savings due to inflation.
  • Investing? Taking risks, depending on your investor profile, in the financial markets or in real estate can bring a potential surplus return in the long run.