Central banks' monetary policies have a significant impact on our daily lives. Especially now that they are trying to curb inflation with interest rate hikes. Central banks set interest rates, which in turn affect the economy, house prices and, of course, your savings account. But aren’t they going too far in this; leading us into recession? They are constantly walking a tightrope between doing too much and too little.
The job of central bankers seems simple: keep prices from fluctuating too much. Central banks decide whether to raise or lower interest rates, actively trying to stimulate or inhibit the economy. Yet it is not nearly as simple as it seems.
By directing policy interest rates to go up or down, central banks influence the costs that banks have to pay on a daily basis. The banks, in turn, pass those costs on to their clients; that’s you. And because an interest rate increase is not for one day, but for a longer period, banks also raise interest rates on loans with maturities that are longer than one day. But what happens next? Theory describes how consumers and businesses respond. When interest rates are higher, you notice it both on savings deposits and on loans. As a result, people will borrow less and save more. After all, borrowing is more expensive, while saving yields more. A thrifty country will consume less and invest less, thus reducing inflation.
Another consequence describes how we feel less prosperous with rising interest rates. For example, we saw in recent months that Dutch home prices fell hard in value compared to last year. After all, mortgage rates rose, making it less attractive to buy a home. So, if you are about to sell your house now, you feel less rich than when you could count on a lot of surplus value. But even if you were not planning to sell your house, this may make you feel less wealthy, and you will adjust your consumption accordingly.
In addition, we see less risk-taking when it is clear that central banks are actively trying to cool the economy. After all, a recession may be coming. That makes banks then less inclined to provide (risky) loans, and financing conditions become stricter. As a result, consumers can borrow and thus spend less, and businesses can invest less.
There are several ways to ensure that higher interest rates lead to lower consumption and investment, resulting in lower inflation. But are we seeing that the policies are working?
At the end of the pandemic, no one expected that the European Central Bank would have to raise interest rates by nearly 5 percent in multiple steps to cool the economy. That it did prove necessary was due in part to a very strong labor market. And unemployment rates are still historically low. When people are not afraid of losing their jobs, the effects mentioned above don’t work as well. You get your salary anyway, and you can also get another job fairly easily. A drink at the cafe may become much more expensive, but restaurants remain fully booked. We are also seeing that interest rates, such as those on a mortgage, are now fixed for longer periods than in previous economic cycles. The Netherlands is one of the countries where consumers lock in their interest rates the longest. If you don’t have to revise your mortgage rate for another 15 years, you won’t notice the higher interest rates until then, unless you move out sooner.