 In line with our strong commitment to our price stability mandate, the governing council took further key steps to make sure that inflation returns to our 2% target over the medium term. We decided to raise the three key ECB interest rates by 50 basis points. You just heard ECB President Christine Lagarde at our Monetary Policy Press Conference on the 21st of July 2022. She announced our decision to raise interest rates by 0.5 percentage points. It's the first time our rates have gone up in 11 years. There's a lot behind our decision. Inflation is high and it's putting a strain on people. This is still mainly due to the very high energy prices, but supply bottlenecks, high demand and a lower exchange rate are pushing up prices too. The economy is also growing more slowly and borrowing is getting more expensive for people and businesses. Many are worried that too high inflation is here to stay. That's why we've raised interest rates, to send the message that we will not allow inflation to stay above 2%. This decision is important for everyone in the euro area, which is why today we're going to explain what interest rates are and what higher rates mean for you, for the economy and for inflation. A couple of weeks ago, before we decided to raise rates, I spoke to Gabriel Gluckler, advisor here at the ECB, about all this and more. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. Gabriel, great to see you again and to have you on the podcast to break down this really important topic for us. Great to be back, Katie. Now, before we get into the whole mechanics of it all, how interest rates work, the real complicated stuff, I really want to just go back to basics. What are interest rates? Well, interest rates are often just loosely talked about as the cost of money, but more correctly will be the cost of credit. And interest rate tells you how high the cost of borrowing is and how high the rewards are for saving. Why do we need them at all? Why can't money just be free? Well, yeah, it's a good point. What economists have are saying is there's no such thing as a free lunch. And I think the same is true also for money. Money is not free and there's an interest to be paid because you could look at it like a compensation for risks about the future and the future is by definition uncertain. So just take an example of you, Katie, who are kind enough to lend me, say, 100 euros so I can buy a flashy pair of new trainers. And then I promise to give their money back to you, say, in three months' time. Now, if we do that, you run a risk. Because in three months' time or over those three months, I could be running off, leave town, never to be seen again. You could run away with said trainers, at the speed of light. I might go broke and I actually have the money to give back to you. I go for a bit. I might die and just not be here anymore. So there are a lot of reasons why you might not actually see your money back after those three months. And therefore you want to be compensated for that risk because you take that risk. And that compensation is the interest I need to pay to you over and above the 100 euros which I need to get back to you. Another way of looking at this is in terms of what economists call the opportunity cost. If you lend me today those 100 euros for three months, you don't have the money available for things that you would like to buy. I'm the one who's losing out. Not necessarily, but there's in a sense a sacrifice now for some reward later, which is when I pay back the money and the interest. True, yes. But for me, it's the other way around. With your money, I can buy those fleshy trainers today that I wouldn't be able to afford otherwise. So I have that benefit of enjoying something today and only pay later and that costs a fee and that's the interest rate. Okay, so it's depending on what side you look at it from. It's an opportunity or it's also a risk. So there's a lot of this compensating for risks taken and that's the interest rate there. Correct. And there's not just those risks. There's also other risks in fact that are all kind of incorporated in interest rates. One thing is we have inflation risk. So go back to the 100 euros that I borrow from you and today they buy me this flashy pair of new trainers. If by the time I give the money back to you, you can only buy a pair of flip flops for that because the purchasing power of that money of those 100 euros has gone down. That's quite a big change in purchasing power but I get the point, yes. Exactly, that's a risk and again you want to be compensated for the risk because after all if you lend me that money you want it back you want the real value of that money back and also that risk that purchasing power goes down also feeds into the interest rate. Okay. And there's another one which we call liquidity risk which is all about the money being available for the use at the right moment in time. So having liquidity available. Correct. So if I promised to put my money in the bank and I basically then lend it to the bank for them to use for other things hand out mortgages and so on but I say okay you can have it and it will sit there for two years say. So you won't touch it for two years. I won't touch it for two years. Then the interest I get from the bank is higher compared to if I always wanted to have it available at any moment in time. That's because I would run a risk that I might unexpectedly need the money so I park that money for two years and if in between I suddenly need that money I short notice then I won't have access to it. So in a sense I have a risk of not being liquid and I want to be compensated for that and that's the higher interest rate. Okay so we've covered what interest rates are and why we need them to cover this this risk these various different types of risk. Let's get to the complicated part how they work. Now interest rates have been low and haven't gone up for a long time especially here in the euro area and some of our younger listeners might not even remember when they last went up. Now Gabriel what happens when rates do go up? Can you explain that to us? Absolutely I will but maybe it's good to go a little bit back in history because it wasn't always like this that rates would go up and down. If we go back in time long enough say around 5000 years that is when the first time the whole concept of interest showed up. So we have records from ancient Babylon back in 3000 before Christ about interest being charged for borrowing grains. It wasn't just that money was also on grain on livestock and the interest that was being charged was a whopping 33 in a third percent. 33 in a third. For grain and for silver it was 25 percent. My goodness. What I find most fascinating is that that rate remained pretty much unchanged for two and a half thousand years until about 500 BC. So Katie you talked about rates not moving for a while. I think that was a very long while there. Well yeah 11 years compared to 2500 quite a big difference. We also then had a long period of time when the very idea of charging interest was considered sinful and therefore in fact outlawed. Christianity for many centuries made no distinction between interest and usury and usury that is kind of an indecently high charge on credit that would be basically unbearable for people who borrowed and ultimately condemn them and sometimes even following generations that children to serve them. And until the modern era the church therefore declared it immoral to charge interest to your brother your sister and to the present day much of the Muslim world disapproves of the notion of interest and we have a field called Islamic finance which works to make modern finance conform with the teachings of the Quran fascinating. Now to the modern times these days in our modern market economies changing interest rates play a powerful steering role. If interest rates go up it means that borrowers have to pay more for a loan and savers enjoy a higher return on their deposits. It's a powerful market signal that determines the zillions of spending saving borrowing and investment decisions that all of us take every day. And that's the key isn't it it's it's all about these decisions that are taken on a daily basis. But what I really want to know is what is our role the ECB's role in all of this. Now when I was preparing for the podcast I did a little experiment and I googled interest rates to see what came up. Now of course the ECB's rates were in there but it was buried amongst millions of results on different types of interest rates all with different names, mortgages, loans even student loans I saw that as well. So obviously the ECB's interest rates are just one of many but where exactly do we fit into all of this? Well maybe the first thing to say is that we as ECB we don't actually set the interest rate that you pay for your loan for your mortgage or that you receive on your savings. But what we do is we influence them. So what you found on your Google search is what we call market rates. And we as a central bank as ECB we can influence those market rates via what we call the key or policy interest rates. So how does that work? Our policy rates are those rates that we set for banks that want to borrow money from us the central bank and for the money they keep with us overnight. Then the interest rates offered by those banks to people and businesses outside move more or less in tandem with our key rates. Okay so basically banks can borrow money from us or put it with us overnight and the rates that they are charged or the rate that they get for that is then passed on through their operations. Okay correct so higher key interest rates so we put up rates higher rates for example mean that money is more expensive so to speak for banks and they pass the cost of money so to speak on to the borrowers and they raise interest rates for people like you and me who come and want to have a mortgage for example. Now this is an impact we spoke about how it affects decisions on how much people businesses, consumers can afford to borrow and by extension this influences how much money they've got left to spend on and invest on the things they would like to do. So if you want to think of an image it's it's a bit like a gas paddle or a break in the car just applied to the economy when accelerating the central bank's lowest rates making the cost of borrowing cheaper and we're putting the foot on the brake the central bank raises rates and this increases them the cost of credit so the overall speed of economic growth to stay with the same image in turn then affects how fast prices in the economy are rising and therefore inflation. Okay you use a car which is not very ecologically friendly so here's my question do our rates determine how much my bank will charge me for a loan to buy an e-bike for example then? That's a lovely example and it's much much better than my car absolutely. They do influence the cost of your loan but there's also lots of other factors of play like the demand and supply of money in a free market economy in other words how much businesses and people want to spend and invest how much money there is available and also how much competition there is for your custom to offer you Katie a loan. Okay so ECB interest rates influence the rates that we get on loans from from our banks but there are also other factors of play okay got it I'm with you. Now obviously the ECB influences the rates for all countries in the eurozone I mean the euro is the official currency in 19 countries soon to be 20 with Croatia but does that mean that the rates on loans and savings are the same across the eurozone so if I go and ask for the same loan in two different countries will I get the same conditions? I think you're pointing to a very important aspect that is very special to the eurozone there Katie as you're saying the eurozone is made up of 19 soon 20 countries and each country is of course different so we here in Frankfurt at the central bank have to make sure that what we decide here actually reaches people and businesses out there in a reasonably even manner across all the countries of the eurozone now that process we call the transmission of monetary policy quite technical now how that works there's various channels there at work they involve banks and financial markets and people's expectations and so on that's how this transmission works basically from here all the way into the economy and it's absolutely essential that those channels work smoothly and without distortions so that our decision here ultimately reaches people and businesses on the ground across the eurozone going back to images which is very important think of it like dropping a stone and a lake if you do that usually it produces pretty uniform ripples across the surface of the water but there could be places for example where the lake is frozen or whether there's driftwood or where there's debris in the water and then suddenly these ripples don't propagate as smoothly because the water has a different properties or different conditions in different places that's a really that's a really good image actually to imagine what it looks like now and that's something that we absolutely have to pay attention to so we don't just have to decide on the what's the right level of interest rates for the eurozone as a whole so what's the right policy right now but we also have to make sure that all corners of the eurozone effectively feel so to speak what we are deciding so let's recap we've learned what interest rates are and now we've also learned how they work and we've even learned about this idea of their effects being transmitted evenly let's turn to the practical side now ECB interest rates are expected to go up it's high time some people say because rates have been very low for very long why exactly has that been the case can you just explain how we got to where we are yes i think it's very important to also frame what's happening so for a long period of time interest rates in the euro area have been very low even negative so below zero particularly after the financial crisis and the european debt crisis so during the past decade or so inflation was very low for a whole range of reasons but it was in fact too low for too long and lower interest rates have helped credit to get cheaper and this in turn then boosts investment and consumption many jobs were created and with many more people in jobs meaning they got income and they go out and spend and the economy recovers and as the economy recovers also prices were slowly increasing again because there's more demand in the economy for things going around absolutely we then came covid and the lockdowns and with with this massive shock to our economies again our low interest rates and making sure that there's enough credit available at favorable rates made sure that the economic hardship that was inevitable with such a huge shock was not more severe and didn't last longer than absolutely necessary you mentioned inflation there gabriel and we are in a very different situation at the moment on that front inflation is too high and that's the context in which we're working at the moment let's look at the practical side of things what exactly does a rate height mean for people for you and me sitting here in our daily lives how will we see that let's make it very concrete a written example say you want to buy a house I need to borrow 100 000 euros at an annual rate that say now is three percent but it used to be one percent this means you will now have to pay your bank 3000 euros in interest per year and not just a thousand in addition of course to paying back the loan mm-hmm that may mean that you maybe other people who are in a similar situation may rethink their decision to buy a house and the same also is true for firms who are wanting credit to expand their business so if if that costs for borrowing goes up they may reconsider but also works the other way around if you say you have more money available that you need right now and you decide to save it and you stick it in the bank the interest is the money that the bank pays you to speak because they borrow in a sense money from you yeah like what we talked about in the beginning exactly and for example if you put 1000 euros in the bank account for your savings and the annual rate of interest is two percent then at the end of the year you will receive 20 euros in interest so instead of spending you see that extra interest coming in and you say maybe it's better to save and not to spend so if we zoom out from you and me and the effect it has on us and look at the broader economy it means fewer purchases by people fewer investments more people will be saving because there's they can get more by leaving their money in the bank that would mean that the economy would cool down right correct that's the mechanism and as a result and that is for us as a central bank the most important thing also the pressure for prices to rise will diminish and hence inflation will come down so for us taking that macro perspective Katie that you mentioned on the economy as a whole the mechanism goes like this in normal times if inflation is too high because there's too much demand and not enough supply we can raise rates to make money more expensive this way we slow down demand and investment and this will gently cool the economy and eventually inflation down you say in normal times Gabriel but I do want to be frank here we're not really in normal times at the moment I mean we've just gone through a pandemic hopefully we're coming out on the other side but who knows whether there will be a new wave and how that would affect the economy we're experiencing war on our borders in Europe for the first time in in over 75 years so it's difficult to speak of normal times you're absolutely right these are not normal times and currently we're facing a very unusual situation which inflation is high but economic growth is actually slowing at least for the short term so Russia's war in Ukraine has pushed up energy prices and food prices and worsen what we call supply bottlenecks just at the moment when they were starting to ease after the pandemic so what does it mean it means that many companies still find it difficult to get the materials the spare part and enough qualified workers that they would need for their production and if they do get it they often find that these inputs have become more expensive now what will firms do then they will eventually pass on those additional costs to their clients and their consumers through higher prices for their products and services so what we're seeing right now is that prices are going up for more and more groups of products and services across more and more sectors of the economy okay so what can higher rates do then in this situation given that it's not we're not in normal times so what higher rates will do is two things first they work why something we call inflation expectations if people and businesses start to think that high inflation is here to stay they want to be compensated so workers will demand higher wages and employers may in turn put up prices now that then turns into some sort of self-fulfilling spiral which we call the wage price spiral workers ask for higher wages companies have to put up prices to be able to pay those higher wages and it just keeps going round correct but we can put if you want to stop sign up there and say we signal we will tackle higher inflation and not just saying it we follow through with our action and that is actually raising rates and we show this way that we will not let expectations of higher inflation become entrenched we will make sure that businesses and workers and investors can be confident that inflation will come down to our two percent target over the medium term so that's one channel via the the inflation expectation second and as mentioned before higher rates also have that cooling effect and they take the pressure off as I mentioned because they can help to bring demand in our economy in line with supply as people and businesses rethink their decisions to spend or invest because rates are going up that counteracts the price rises that we see spreading and ultimately reduces inflation okay so higher rates will help to bring people's inflation expectations down and it will also help to cool down the economy by by reducing demand a bit okay there is one last aspect that I want to ask you about and that's kind of I would say the word that has characterized at least the last few months and that's uncertainty we don't know when the war will end for example I also said we don't know what will come for the pandemic what's next what can you do about that well we at central bank we cannot take away the uncertainty about the future states of the world this we cannot do what we can do is take away any uncertainty about our commitment to do what is necessary and ECB President Christine Lagarde has explained several times that we're now on what she calls a journey to normalize monetary policy so to move away from some of the unconventional measures that we have used over the over the last few years and in terms of interest rates the topic of our of our podcast today we now talk about a sustained path of interest rate hikes so this is this journey that Christine Lagarde referred to which of course starts with the first step the one we're expecting but there are more to come and how fast those further steps will be taken and how big those steps will be depends on how the economy develops and how we see in our assessment how inflation is evolving thank you Gabriel this has really been a very insightful and important conversation so i'm really grateful for you taking the time to to break down this topic for us now before we wrap up as you know as a regular to the podcast we always have a question that we ask our guests and that's for a hot tip linked to the topic we're discussing today Gabriel what do you have for our listeners right for our topic today i would recommend a fascinating book by the late David Grabo and it's called that the first 5000 years i found a very very stimulating he's an anthropologist and in his book he takes us on a fascinating tour covering millennia and many different civilizations and cultures to show how concepts like debt credit or money which are pretty abstract relate to people's social relationships what happens between people to the institutions they create for their societies and to the power that's exercise there in fact some of the nuggets about the the ancient history that i mentioned earlier are also treated in his book i wanted to say actually anyone who liked your anecdotes at the beginning would certainly be into this book i reckon absolutely the best bit it's not dry it's written very well in a very engaging style and of course you may not agree with his premises or where he ultimately takes his argument but i could not help but admire his efforts to fundamentally challenge and he won't unhinge a whole conceptual edifice of how money finance and markets work okay i've been working at the ecb and in central banking for over 20 years you weren't really at the heart of today's money system and i found it refreshing to think in new ways about this system and follow him and how he questions many of to speak the truth that we hold to be self-evident in this field so a very fascinating and stimulating read okay david grober debt the first 5000 years a another brilliant hot tip thank you so much gabriel thank you katie it's been a pleasure so what's next well our decision to raise interest rates is a further step in normalising our monetary policy more rate hikes will come and they'll depend on how we see the economy and inflation developing these rate increases will help bring inflation back to our two percent target if you want to learn more about this topic we've lots of resources on our website you can find all the links to those in the show notes that brings us to the end of this episode i want to thank gabriel gluckler for discussing with me what interest rates are and what higher rates mean for people the economy and inflation you've been listening to the ecb podcast with katie ranger if you like what you've heard please subscribe and leave us a review until next time thanks for listening