Brussels – The European Central Bank’s interest rate decisions affect the real economy. How? By making it less attractive to borrow money. The cost of capital rises, leading to a reduction in demand. Let’s look at what this means in more detail.
What does an interest rate rise mean
A rise in interest rates is simply a decision to increase the cost at which central banks lend money to banks. Money becomes more expensive, and this increased cost is passed on to customers (the public and business owners) when they apply for loans or have to pay the next instalments on mortgages and loans already taken out at a “variable rate”. In essence, it becomes less affordable and therefore less attractive to take out new mortgages and make investments.
Shares and bonds
Speaking of investments, a rise in interest rates affects the decisions of those wishing to invest part of their savings. Are shares or bonds the better option? In this case, the decision to increase borrowing costs actually shifts the flow of money. Shares become less attractive than bonds, with savers less inclined to invest in the stock market. This is because bonds offer higher yields, whereas shares may yield lower returns.
The rise in public debt rates
A rise in interest rates also penalises governments, as the interest they have to pay on their sovereign debt securities increases. For countries such as Italy, which have high public debt relative to gross domestic product, rising interest rates exacerbate the burden of repaying bearer bonds.
Implications for banks and the real economy
Banks can increase profits by lending at higher rates, which means more cash for credit institutions. At the same time, however, this means that both existing mortgages and new loans are exposed to a greater risk of default by households and businesses, which exacerbates the phenomenon of non-performing loans (loans that are difficult to recover). In practice, to avoid exposing themselves to these risks, banks may make it more difficult for households and businesses to obtain new loans by imposing stricter conditions.
