A rise in ECB interest rates can have a transitional impact on the UK despite the UK having left the EU banking system. The governing council’s recent interest rate hike increased the MRO, marginal lending, and deposit interest rates to 4.25%,4.50%, and 3.75%, respectively.
The annual inflation rate in Europe reached 9.9% in 2022. Subsequently, the European Central Bank (ECB) increased the key interest rate for the first time in over a decade in July 2022. Afterwards, the interest rate increased again in September, October, and December. The governing council again decided to increase the three key interest rates by 25 basis points in July 2023.
The underlying goal of increasing the interest rates is to bring inflation down to 2% in a timely manner. Recent macroeconomic forecasts have shown that inflation in the Euro area is likely to be 5.4% in 2023, 3.0% in 2024, and 2.2% by 2025. But although ECB interest rates don’t directly impact the United Kingdom (UK) since it’s no longer a part of the European Union (EU), they have a transitional impact.
Why does the ECB have three key interest rates?
The key interest rate determines commercial banks’ conditions when borrowing or investing money from or with the central bank and simulates financial markets. It’s important to understand that low interest rates help stimulate economic growth, whereas high interest rates slow down economic activity.
The ECB sets the key interest rates for the eurozone and divides them into three categories based on their functions. They influence consumer behaviour, savings, and investments. Let’s look at the three key ECB interest rates in more detail for a better understanding.
Main refinancing operations rate
This is the ECB’s key interest rate. The main financing operations (MRO) rate is the interest banks have to pay when they borrow money from the ECB for a short or medium-term duration. Low MRO rates help commercial banks provide loans at a feasible rate but also decrease the interest customers receive on savings. In contrast, a high MRO rate makes getting a loan difficult but increases interest received on savings.
Marginal lending rate
The marginal lending rate is the interest banks pay when borrowing money from the ECB overnight. In such cases, commercial banks have to provide collateral, such as securities, to guarantee that they will repay the money. The marginal lending facility rate is often higher than the MRO and can help slow inflation. However, inflation can prevail quickly if the marginal lending rate is low.
Deposit facility rate
The deposit interest rate is the interest the ECB sets as part of its monetary policy. This is the rate at which commercial banks receive interest for overnight deposits made to the ECB. However, if the deposit facility rate dives to a negative value, the commercial banks must pay the ECB for depositing their money
How does the ECB increase or decrease interest rates?
These interest rates are part of the ECB’s monetary policy, and the ECB President, Christine Lagarde, and the governing council set these rates every six weeks. An increase or decrease is in percentage points, and the rate decision is made based on real-time factors.
Interest rates are either increased or decreased to derive price stability among currencies within the Eurosystem as they can influence the exchange rate. Changes in interest rates can also derive financial stability. The ECB can also issue banknotes within the eurozone and conduct foreign exchange operations.
What are the current key ECB interest rates?
The governing council of the ECB decided to increase interest rates back in June 2023 by 25 basis points. Given that decision, the MRO rate stood at 4.00%, the marginal lending rate stood at 4.25%, and the deposit facility rate was 3.50%.
However, the governing council has continued to increase the key interest rates. As of August 2023, the MRO rate is 4.25%, the marginal lending rate is 4.50%, and the deposit facility rate is 3.75%.
What happens when the ECB increases the Interest rates?
When the ECB does decide to increase the interest rate, commercial banks will have to pay more to borrow money. Banks often charge customers more for loans to offset costs imposed due to the increased interest rate. Due to this, banks and customers reduce their borrowing frequency. This decreases the money supply, increases value, and lowers prices.
What happens when the ECB decreases the Interest rates?
When the ECB decides to lower the interest rates, commercial banks can borrow and loan out money at low interest rates. However, this also decreases the interest customers receive on savings. Due to such factors, customers and businesses tend to increase their spending. This stimulates economic activity. However, it can also lead to an increase in prices and, in severe cases, inflation.
Do ECB interest rates have an impact on the UK?
Most people often think the key ECB interest rates don’t impact the UK. This statement is true to a certain extent since the UK is no longer a part of the EU and has its own central bank. However, the UK continues to trade with countries in the eurozone.
Therefore, the ECB interest rate increases may not directly impact the UK, but these increases will have a transitional impact. An increase in interest rates imposed by the EU aims to reduce inflation and make the Euro more valuable.
When the Euro increases in value, it will likely become more attractive to investors and perform better exchange rates. The British pound (GBP) is currently more powerful than the (EUR). However, the continuous interest rate hike could strengthen the Euro and cause the GBP to lose its value.
This means that the UK, which has economic relations with the EU, will likely experience expensive imports and may face difficulty exporting products. Statistics have shown that the UK had exports worth £340 billion to the EU. The nation’s total EU imports, including countries like Germany, France, and Italy, were worth £432 billion in 2022. In addition, the 2022 imports from China and Russia were worth £86.78 billion and £5.39 billion.
Based on their imports and exports with the EU, the UK experienced a trade deficit of £92 billion in 2022. However, if the euro becomes a more valuable and high-performing currency, then this deficit may increase. In addition, consumer prices in the UK can also rise given that imports will be more expensive.
ECB interest rate and the UK
The ECB has the same purpose as the Federal Reserve Bank, but for the EU. The ECB interest rates are either increased or decreased to stabilise prices and control inflation. These rates include the MRO, marginal lending, and deposit rates. Changes in these rates influence how commercial banks withdraw or deposit with the ECB. However, since the UK is no longer a part of the EU, changes in these rates have a transitional impact on the UK.