ECB Raises Interest Rates

The European Central Bank is taking measures to counter a weakening euro and persistently high inflation. On July 21st the ECB’s Governing Council announced:

Today, in line with the Governing Council’s strong commitment to its price stability mandate, the Governing Council took further key steps to make sure inflation returns to its 2% target over the medium term. The Governing Council decided to raise the three key ECB interest rates by 50 basis points.

One of the interest rates is for the so-called marginal lending facility, which is now at 0.75%. This is an instrument with which commercial banks can balance out their cash flows overnight. A low rate on the marginal lending facility incentivizes banks to hold less cash reserves and rely on overnight loans from the ECB when margins are negative. By raising this interest rate, the ECB incentivizes banks to increase their cash balances and, on the margin, issue fewer short-term loans to commercial and private customers.

The ECB also raised the interest rate on the deposit facility. This rate regulates the return that commercial banks get if they deposit net cash balances with the central bank instead of keeping them on their books. For the past eight years, the deposit-facility rate has been negative: banks have been forced to pay a fee equal to the negative interest rate, in order to deposit cash with the central bank.

A negative rate on the deposit facility is an instrument for expansionary monetary policy. It is meant to encourage banks to issue loans with their excess cash, or to otherwise invest it. With this interest rate raised from -0.5% to zero, the ECB no longer punishes banks for cash deposits; an interest rate of zero neutralizes the deposit facility as a monetary-policy instrument. 

The ECB’s interest-rate increases come on the heels of the Federal Reserve raising its federal funds rate three times since March, from 0.08% to 1.58%. It also follows the weakening of the euro vs. the U.S. dollar, which temporarily reached parity on July 14th, and vs. the Russian ruble. At the beginning of the year, the Russian currency traded at €12 per 100 rubles; as of July 19th the exchange rate was €17 per 100 rubles. 

When the ECB raises interest rates, all other things equal it increases demand for euros on the global foreign-exchange market. This strengthens the euro vs. other currencies.