ING Podcast

Changing Rates: How to Find the Right Balance

Philippe Ledent, Expert Economist at ING Belgium-Luxembourg

Narrator: We all know that interest rates are a key factor for all of us. Many bank financial products, both deposits and loans, are also seeing their rates rise.

But what is the central bank’s impact on rate developments? And why are rates rising, even when common sense suggests that now is not the right time? 

Today, we talk with Philippe Ledent, senior economist at ING. Hello Philippe!

Philippe: Hello, hello everyone!

Philippe: Let’s start with two basic principles. 

First, in an economy, in financial markets, all interest rates are linked. It’s easy to understand: you can’t borrow money for a certain duration with a certain risk, and invest it for the same duration with the same risk, while making money. That is not possible. 

That means that all interest rates are still interconnected.

Jim: So it's both the rates I pay on a loan and the rates I get on deposits?

Philippe: Exactly. Second, the banking sector is merely a financial intermediary. 

This means that bank product rates are also linked to each other, and to financial-market rates.

Philippe: There are several reasons why interest rates move in financial markets. Fundamentally, it is a matter of supply and demand for capital.

But there is another key factor: the influence of central banks.

Financial markets want to finance the economy—that is their raison d’être. But for that, they need fresh liquidity, provided by the central bank.

And that money is not free: the central bank lends it at a certain interest rate.

This rate strongly influences all other rates in the financial market and in the banking sector.

Jim: Do all market rates respond the same to central bank rates?

Philippe: No. Two things come into play:

1. The level of risk, which can create large differences between rate types.
2. The duration.

When the central bank lends to the economy, it does so through short-term operations.

So short-term rates (3 months, 6 months, 1 year) react immediately to any change in the policy rate.

For long-term rates (10, 15, 20 years), it is more complex.

Imagine that I borrow for 10 years. The rate will be influenced by the current short-term rate (defined by the central bank), but also by market expectations about the future evolution of these rates.

In other words, markets try to “read the mind” of the central banker.

By looking at long-term rates, one can understand what the market thinks the central bank will do in the future.

This is crucial for companies that invest in the long term, or for mortgages, which are also long-term loans.

Jim: There's a lot of talk about rising prices in the economy. What is the impact on interest rates?

Philippe: That's exactly the point.

We're currently experiencing high inflation—that's a broad-based increase in consumer prices—of over 8% in some regions, in Europe, in the United States, around the world.

The central bank has two responsibilities:

1. Providing new money to the economy.

2. Maintain stable inflation over the medium term.

The current level of inflation is far too high. So the central bank has to act, and that means raising the rate at which it lends money.

But this has a direct consequence: for people with loans, repayments become higher.

For example, repayments by borrowers can rise. And that’s precisely what this policy is about.

By increasing the rate at which the central bank lends money to financial markets, it puts upward pressure on all interest rates.

This means that what I pay for a loan or mortgage, or what I receive on my deposit, will also increase.

This shift influences consumer and business behavior, which helps to slow inflation.

Jim: So the reason the banks are raising rates is that they're expecting more increases later this year?

Philippe: Exactly. It's all related to financial markets.

Markets anticipate higher rates in the coming quarters.

And as they anticipate, there is already an increase in long-term yields, which affects all long-term interest rates in the economy, including banking products.

Jim: But if rates are supposed to cool the economy, isn’t there a risk of cooling it too much and causing a recession?

Philippe: That's an excellent point. This shows that managing monetary policy is not easy.

Raising rates is aimed at slowing consumer credit, slowing investment, encouraging people to save more and consume less.

These are the channels through which a higher rate slows aggregate demand.

Why? Because inflation reflects an imbalance between too much demand and too little supply.

The central bank wants to slow that demand.

And conversely, when it wants to support the economy, it lowers rates to stimulate demand.

So by adjusting rates, it seeks to influence aggregate demand—either to slow it down or to stimulate it.

Philippe:But if we go too far, there is a real risk: we are happy because inflation is falling, but demand is becoming too low, and this can cause a recession.

This has happened in the past.

We must therefore find the right balance.

We cannot increase rates indefinitely, because at some point it becomes dangerous for the economy.

Jim: It seems counterintuitive to raise rates when the economy is not operating at full capacity...

Philippe: Yes, especially in the euro area, where we are seeing an economic slowdown.

But it's a bit of a choice of the lesser evil.

On the one hand, you might ask why we're doing this now.

But on the other hand, we have to remember that inflation is very high, and it's also bad for the economy and bad for people.

Some might say, “If my income is indexed to inflation, I don’t care. Prices are up by 8%, but so are my wages.”

But not everyone.

Most people in the eurozone do not have indexed incomes.

So, for many people and businesses, such high inflation - well above the usual 2% - is very problematic.

The central bank needs to think about overall well-being, not just those who are suffering from rising rates.

Taking into account all the negative consequences of too high inflation, it is important to act on interest rates, even if the economy is not doing as well as we would like.

The goal is to fight inflation that hurts people and businesses.

Jim: Thank you, Philippe, for that very comprehensive explanation.

We're coming to the end of our survey: we're seeing big movements in financial product rates, because market conditions are changing.

And they're changing because we're anticipating increases in central bank rates—increases that have already started everywhere.

Those increases are driven by the desire to regain control over what is, frankly, a record-breaking inflation.

Is that a good summary, Philippe?

Philippe: Perfect!

Jim: It was Philippe Ledent, senior economist at ING. Thank you very much! 

Feel free to contact your ING team if you have any questions or to discuss your personal situation. Find all useful contacts on ing.lu/service.