What is Base Rate? How is It Determined?

What is base rate? The key interest rate set by the CB is an important instrument of monetary policy. Is the CB lowering the key rate? More than once this question was answered with yes. But what actually is the key interest rate and what is the significance of cuts or increases? We look at the implications for monetary policy and private investors. We also show how the key interest rate has developed in the past.

Base interest rates play an important role in the monetary policy of every central or central bank. The base rate denotes the interest rate at which the central bank conducts business with commercial banks. It is set unilaterally, the banks only have the option to conclude deals or to forego it. The central bank thus influences interest rate developments and has an indirect influence on the banks’ deposit and credit policies. Strictly speaking, the term “the key rate” is a bit misleading. Because there are usually several interest rates or interest ranges in which central banks offer the credit institutions different types of business. Specifically, there are three interest rates at the CB:

The main refinancing rate: At this rate, commercial banks can borrow money from the CB for short periods of one week or more. When the key CB interest rate is mentioned, the main refinancing rate is very often referred to. It is the most important of the three interest rates and is the focus of public reporting.

The deposit rate: It denotes the interest rate at which banks can temporarily park excess liquidity with the CB until the next day. You are then practically yourself a short-term investor. This setting of interest rates mainly affects the investment and lending rates . The deposit rate is otherwise less considered, but it made a name for itself when the CB first introduced negative interest rates. In addition, the deposit rate represents the lower interest limit for the overnight money.

What functions does the key rate have?

The key interest rate is a key monetary policy control instrument. The banks base their conditions on the conditions for their own business with the central bank. The central bank is a key financing partner for them. If the key interest rate is lowered, this tends to lead to cheaper loans and lower interest rates on investments. The banks can then obtain more affordable liquidity from the central bank themselves and extend more loans. At the same time, they are less dependent on their customers’ deposits – because they can fall back on the money of the central banks. A rate hike has exactly the opposite effect.

The original function of the (key) interest rate policy is to secure price stability through low inflation. If the signs of inflation multiply, the central bank will raise the key interest rate to curb bank lending. At the same time, this makes spending more difficult for private households and companies. Reins are placed on excessive demand, the money supply becomes scarce and inflation slows down. Such rate hikes often take place in phases of economic boom. In times of economic downturn, however, the central bank tends to react by lowering the key interest rate to prevent deflation. In the worst case, a deflationary spiral occurs – a slide into a self-reinforcing economic downturn.

The ultimate goal of CB: to generate more economic growth to cope with the crisis.

Exchange rate effects of key interest rates: A further effect of interest rate policy can be exchange rate effects. Interest rate differentials are an explanatory variable for changes in exchange rates. Lower key interest rates tend to make one’s own currency “softer” because there is increasing demand for money from currency areas with higher interest rates. This also has an overall economic effect. Exports are favored when exchange rates are weaker and imports are made more expensive.

It should not be forgotten that changes in key interest rates also have an important signal function beyond their pure economic effect. They indicate the direction in which the central bank is moving with its monetary policy and how it assesses the economic situation. Exchanges register and “process” such signals with particular sensitivity. Moreover, key rate hikes are unlikely in the near future. The CB has made it clear that it intends to stick to its low interest rate policy and its monetary expansion for the time being in order to cope with the consequences of the corona.

What is the impact of the key interest rate on bank conditions?

Central bank dealings with the banks are short-term in nature. Accordingly, the key interest rates are short-term interest rates. Changes in key interest rates are therefore the quickest and most direct way of influencing conditions on the short-term money market. In the case of medium- and longer-term interest rates, however, the effect is not quite as “striking”. Changes in interest rates often only arrive with a time lag and are weakened. In the case of long-term interest rates, other influences are often also relevant for interest rate developments. This can mean that a key rate change “at the long end” is largely ignored, but it does not have to be.

Looking at the development of interest rates for various banking transactions over the past few years , the following can be determined:

The conditions for bank deposits (overnight money, time deposits, savings deposits) have reacted comparatively sensitively to changes in key interest rates – with resistance at the zero interest rate line. Negative interest rates in the banks’ deposit business remain the exception – despite negative interest rates for the CB deposit rate that have existed for some time. The overdraft rates react relatively sluggishly to changes in key interest rates and only move moderately.

The interest rates for installment loans have roughly followed the key rate trend – with a time delay and with a significant interest rate gap.

“One man’s joy is another’s pain”, this old saying seems made for changes in key interest rates. Falling key interest rates tend to make financing cheaper for borrowers. It then becomes easier to take out loans and bear the burden of interest and repayment. For investors and savers, however, it becomes less profitable to save in interest-bearing investments . Alternatives are required for investing – for example stocks, equity funds, ETFs or other asset classes. The stock exchange likes to react to interest rate cuts with “jumping for joy” in the form of price gains because companies benefit from lower interest rates. But that is not automatic. With higher key interest rates, the opposite is true.

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