There has been a great deal of chatter about this rate hike of 50 bps in the media, but not many went to the extent of clearly explaining this mechanism and what does this exactly mean. The truth is, the Governing Council of the ECB sets 3 key interest rates, which were all altered in this latest hike. Let’s cover each one in detail:

Rate on Main Refinancing Operations

Perhaps the most important of all 3 key rates for the ECB, the Rate on Main Refinancing Operations (MRO) is the main driver of liquidity to the European banking system. In simple terms, this is the rate at which banks can borrow from the ECB for a period of one week. Essentially, when banks are in need of liquidity, they can have access to this facility and borrow from the Eurosystem, by providing collateral.

Since last week, this rate is now set at 0.50% after a long period of 0.00%.

Rate on the Deposit Facility

Contrary to the previous example, the Rate on the Deposit Facility is the interest received by banks for making overnight deposits with the ECB. Ever since the Global Financial Crisis broke and threatened the stability of the global economy, the ECB (and other Central Banks) has been making sure that this rate stays as low as possible, and the idea behind this thinking is to ensure that banks are not incentivised to deposit their excess reserves, but instead to lend this liquidity directly into the economy to stimulate consumption and investment.

The above clearly demonstrates this in practice. Not only did the ECB lower this rate to 0%, but in 2014 they “experimented” with negative rates (going as low as -0.50% in 2019), a clear message to commercial banks that their liquidity should not be parked with the central bank but passed on to families and companies.This rate is now 0.00%.

Rate on the Marginal Lending Facility

The last of the 3 key interest rates set by the ECB is the Rate on the Marginal Lending Facility. This lending instrument is in all similar to the Rate on the Main Refinancing Operations, but instead of banks borrowing from the ECB for a period of one week, this facility is used for overnight loans. Banks still have to provide collateral for this lending facility and will be charged a higher rate compared to the MRO. This rate was also raised by 50 bps, to 0.70%.

What does this mean?

Inflation has been a dominant topic in 2022 and Monetary Policy by Central Banks have been under the spotlight for this reason.

After years of zero or near-zero interest rates, to stimulate the economy by incentivising investment and consumption, Central Banks were now forced to put the brakes on this dynamic in an attempt to tame inflation by forcing the economies to slow down.

When interest rates are moving to the upside, credit becomes more expensive, businesses cool down, asset prices may become more volatile and the money supply falls. All of this converges to the ultimate expectation of bringing inflation down to an acceptable level and ensuring price stability, which, at the end of the day, is the primary objective of Central Banks.