When will money become cheaper?
Why the interest rate turnaround is a question of fate for the economy
By Max Bourne
April 5, 2024, 6:52 p.m
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Is it coming in June or maybe earlier? Will it remain a single small step or will others quickly follow? The expected interest rate cuts by the European Central Bank and the American Federal Reserve have been the most discussed topic on the financial markets for weeks. Any speculation about even the smallest changes to the timing and extent of the so-called interest rate turnaround moves the prices of stocks, gold or Bitcoin. But the significance of the upcoming interest rate decisions goes far beyond the financial market. The central bankers have a say in the development of – among other things – real estate prices, rents and overall economic growth and thus our incomes. The most important questions and answers.
Interest rate decisions are a routine task for a central bank. Why should this be so important for all of us this time?
As a rule, it is mainly financial nerds who wait eagerly month after month to see whether the central bankers will change the key interest rates by one decimal place or what they will say about the “interest rate path” for the coming months. Sometimes, however, monetary authorities find themselves at a turning point where their decisions influence all areas of the economy more strongly than usual and quite directly. Now is such a time. After years of zero and negative interest rates, the ECB raised key interest rates again last year at an unprecedented pace in order to combat inflation. This had severe negative effects on the entire economy, which was already weakened by the Corona and energy crisis. Whether and to what extent these effects are reversed and economic growth gains momentum depends on the timing of the interest rate hikes and their amount.
Why are lower interest rates important to get the economy moving?
The extremely rapid rise in interest rates over the past two years has made money – for example in the form of loans – much more expensive for both consumers and companies, as well as for the state. The ECB’s credit cost index shows an almost quadrupling between the end of 2021 and autumn 2023. As a result, consumption and investment were severely slowed down. Falling interest rates have the opposite effect of boosting investment and consumption. Another effect is that the euro’s exchange rate against other currencies tends to be depressed because capital tends to flow to countries with higher interest rates. A weaker euro would support the competitiveness of German industry abroad because its exports would become cheaper for customers in other currency areas.
What does interest rate policy have to do with the housing market?
The sectors hit hardest by rising financing costs include the real estate market and the construction industry. A few years ago, mortgage loans for private builders were sometimes granted for less than one percent, but now the figure is around three and a half percent. The interest costs for a real estate loan of 500,000 euros, for example, have increased from a few tens of thousands of euros to several hundred thousand euros. This has made many construction projects – both single-family and multi-family homes – simply unfinanceable. Instead of being promised by politicians for years, housing construction has not picked up but has collapsed. This has further deteriorated the relationship between supply and demand on the rental market and pushed up rents. Other factors such as increased construction costs and the lack of building land are also slowing down housing construction. Significantly falling interest costs would at least bring noticeable relief in the current construction crisis.
What does the interest rate turnaround mean for savers and investors?
People who invested their money in a classic savings account, fixed-term deposit account or similar remember the era of low interest rates with horror. After last year’s key interest rate increases, most banks and savings banks only raised the interest rates for their customers minimally. In real terms, i.e. after deducting inflation, such forms of savings almost never produced any significant returns. This is not the case currently either. In return, interest rate cuts make other forms of investment more attractive again.
Which investments benefit from interest rate cuts?
The expectation of interest rate cuts alone has triggered a so-called everything rally on the stock markets. The expectation is that if the central banks make money cheaper, more of it will flow to the stock market. Stocks also benefit from hopes of rising corporate profits through lower financing costs and an improving economy. The interest rate development has a particularly strong impact on shares of companies that were primarily focused on growth and – not yet – making any profits, including many companies in the technology sector. Rising interest rates had made financing such companies much more difficult. It should now become easier again to manage high investments over longer periods of time.