Interest rate policy: What strategies are central banks pursuing?

The interest rate policies of leading central banks

First, it is important to understand the connection between interest rate hikes and the fight against inflation. The level of the key interest rate set by central banks has an impact on construction, credit and savings interest rates. Put simply, lower interest rates lead to an increase in lending. As a result, consumers and companies spend more money, causing inflation to rise.

If, on the other hand, interest rates are raised and the “loan money” is therefore more expensive, more is saved and less money is spent. Although this slows down economic growth, it also lowers inflation at the same time. Central banks use this mechanism to keep the economy in balance through stable prices for consumers and companies.

• The ECB (European Central Bank), for example, has the goal of reducing inflation to two percent through interest rate hikes. After several major interest rate hikes since summer 2022, the currency authorities have Key interest rate at three percent in February 2023 defined. According to many experts, however, the end of the flag pole is unlikely to have been reached yet, as the inflation target is a long way off.

• The Fed (US Federal Reserve) heralded the end of the long-standing zero-interest rate policy back in March 2022. Accordingly, the US key interest rate is already significantly higher than the EU key interest rate: After eight increases, it is in the Range of 4.5 to 4.75 percent (As of February 2023). Minor interest rate hikes are now expected as the inflation rate in the USA continues to fall — a sign of the first successes of strict monetary policy. In January, consumer prices rose by 6.4 percent compared to the same month of the previous year. In November, the rate was still 7.1 percent. In the long term, however, the Fed is also aiming for an inflation rate of two percent and is therefore likely to plan further interest rate hikes.

• The People's Bank of China, on the other hand, is using unusual methods. While interest rates are rising all over the world to combat inflation, China's central bank stepped back against the economic downturn, particularly due to corona, with a surprising cut in key interest rates. Among other things, central bankers lowered the reference interest rate for one-year loans 2.75 from the previous 2.85 percent and have stuck to it up to now.

Implications for companies and consumers

The current restrictive interest rate policy of the EU and US Federal Reserve is primarily aimed at reducing the amount of money in circulation and thus reducing inflation. However, the currency authorities are entering difficult territory. Because when interest rates rise too much, economic growth is strangled. In the most likely case, however, central banks' interest rate hikes will have the following consequences:

• Consequences for the economy:

Because many companies invest less due to higher interest rates on loans, consumption is slowing and there are also ongoing supply chain problems and production outages, the economy could temporarily collapse. A recession is also possible. This happens when a country's economy shrinks for two quarters in a row, unemployment figures rise and tax revenues plummet. Only a mild recession, if at all, is currently expected for the USA and Germany. On the other hand, the risk of stagflation — continued economic weakness combined with rising prices — is increasing.

• Consequences for consumers:

For one person, pain for another: There is finally credit interest again for savers, but it is becoming more expensive for borrowers and real estate buyers. The interest rates paid by banks on balances in call money accounts and fixed-term deposit accounts have been rising for several months. In addition, the custody fee for large amounts of money in the current account at the vast majority of banks is eliminated.

On the other hand, loans, particularly real estate loans, are becoming more expensive. However, the level of construction interest rates is not directly dependent on ECB interest rate decisions, but is based on the interest rate on federal bonds. Higher interest rates particularly affect those who need a new loan or follow-up financing for a real estate loan.

It can currently be assumed that both inflation and interest rate hikes will be “here to stay” for a while. So said the head of the US Federal Reserve, Jerome Powell, in February 2023 that a restrictive policy must be expected “for some time”. This means that even if economic growth slows down, key interest rate cuts should not be expected as long as the inflation problem persists.

Inflation protection for portfolios is more important than ever

What does this mean for private investors? On the one hand, rising interest rates make it possible for capital that is not needed in the medium term to be invested in fixed-term deposit accounts again with interest. However, it should be noted that the interest rate that banks pay is currently well below the inflation rate. That is why savings are constantly losing value despite interest rates.

Equity markets, on the other hand, could once again offer attractive entry opportunities. Alone the Dax has almost nine percent in January increased because investors speculate that at least the pace and level of interest rate hikes will decrease. But there are also risks associated with company shares. Companies can get into difficulties because, for example, new competitors enter a market or consumers change their consumption habits.

It therefore makes sense to structure a portfolio as diversified as possible and also to add tangible assets that have little market correlation. These include collectibles such as art, classic cars or luxury watches as well as real estate. The tokenization of tangible assets into digital shares even opens up investment opportunities for private investors in the areas of collectibles, real estate and private equity, which otherwise only institutional investors can take advantage of.

‍