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Where low interest rates come from and what they mean for investors

For 30 to 35 years, the interest rates that savers receive for money investments have fallen more or less continuously. The discount rate of the German Bundesbank, the predecessor of the ECB, was 7.50 percent in 1980, then fell to 2.50 percent by 1988 and rose again to 8.75 percent due to reunification before the steady decline of the key interest rate began. The rate cuts were accelerated by the economic crises due to the dot-com bubble in 2000 and the great subprime financial crisis in 2007⁄08. Investors benefited from this in mortgage rates: actually, for the last 35 years, mortgage rates have always been going downhill. After reunification, there was a short and sharp increase of 2.5 percentage points and since then, construction interest rates have become cheaper and cheaper.


Market interest rates depend on the level of the base rate. The key interest rate is the so-called main refinancing rate. This is the rate at which commercial banks are lent money by the European Central Bank (ECB). The interbank rates such as Eonia and Euribor for money trading between commercial banks react very strongly to changes in the key interest rate level.

Interbank rates from the money market have a major influence on the development of market interest rates for businesses and consumers. The interest rate for short-term money investments is directly linked to the level of the key interest rate. The medium to long-term yields on money investments depend on the average interest rate on long-term government bonds - the current yield - which serves as the reference interest rate. It is formed by supply and demand on the capital market, which are brought about by expectations of economic growth and inflation. Interest rates on deposits and bonds thus depend primarily on the economic and monetary situation of an economy.


The key interest rate is an important part of the central bank's monetary policy and is determined at its regular meetings. In Europe, the ECB is the supreme monetary institution. The central bankers base their interest rate decisions on the economic indicators of the national economy(s):

  • How are exports, imports, and the money supply growing?

  • What is the level of the exchange rate and economic or price indices?

  • Are the growth prospects for the economy good or are they dimming?

  • What is the inflation rate? Can inflation or deflation be expected to rise?

Central bankers have to assess this responsibly for the future because the key interest rate not only influences financial investments, but also the cost of capital derived from this is the interest rate at which investments are financed with borrowed capital. The key interest rate is intended to promote or slow down growth via the loans issued by banks to companies and investors. The companies that receive new capital through loans, shares, or bonds are supposed to invest it in new jobs and projects.

The money supply can also be controlled by other monetary policy measures of the central bank. These can be, for example, the levying of penalty interest on deposits of commercial banks at the central bank, the purchase of bank bonds, or extra loans for the financial institutions, which are to pass on these additional funds to the economy at special conditions. For economic participants, the question is: at what interest rate level is it worthwhile to finance investments with loans instead of saving money?

How high the interest rate for bank deposits and loans actually also depends on the competitive situation in the banking industry and the economic situation of the institutions. The interest rates for long-term bonds are primarily defined by the assessment of the risk. With what probability will the issuer of the bond repay the investor's capital? How do investors or rating agencies assess the issuer's ability to repay? The interest rate is the compensation for the risk taken by the buyers of the bond.


After the great financial crisis, it was necessary to restore and maintain the flow of money between banks. Since confidence in banks and between financial institutions had been lost, the ECB's monetary policy had to intervene and stimulate lending by lowering interest rates. The first interest rate cuts were not enough to normalize the economic cycle. Added to this were the effects of the restrictive interest rate policies in the USA, Japan, and large parts of the world. Thus, key interest rates were gradually lowered to today's level of 0.05 percent. There was an exorbitant expansion of debt in many areas. The goal of this monetary policy stimulation is still a higher inflation rate. This lowers the monetary value of liabilities. This helps borrowers because it reduces the real value of their debt.

The ECB also influences the level of long-term interest rates by buying government bonds. These are considered practically risk-free because they are theoretically not at risk of default. The more government bonds the ECB buys on the market, the lower the interest rate level becomes because the prices of the bonds rise due to the increase in demand. Investors assess German government bonds, for example, as risk-free; their probability of default is almost zero. Therefore, the federal government does not have to pay interest to investors; on the contrary, it can even charge interest for the purchase of its bonds.


To date, the ECB has not succeeded in achieving the desired inflation rate of two percent and adequate economic growth through its low-interest rate policy. This is because the population in Europe is shrinking and getting older, a saturation level has been reached for consumer and economic goods, and other goals such as sustainability and ethics are becoming more important. The low inflation rate is due to a prolonged decline in oil prices, which in turn is due to weak global growth and excess supply in the market. In addition, there is a global currency devaluation race. Last but not least, corporate and consumer debt has reached proportions that make unlimited credit growth impossible. The states are moving at the limit of a bearable debt burden. Moreover, the euro levels interest rates to a uniform level, but not the economic strength of the countries. Export-strong countries like Germany benefit most from the devaluation of the euro, for which a higher key interest rate would actually be appropriate.


Low-interest rates have different effects on creditors and debtors. The savings rate falls because it is supposedly no longer worth saving. The low compound interest effect on longer-term retirement savings contributes to this. A direct consequence of this is that consumption wishes are realized immediately and no longer postponed into the future. Due to the banking crisis, cash and safe as well as liquid investments have gained in importance.

Borrowers are tempted by low-interest rates to take on more and more debt until an unjustifiable level is reached. An incentive is created to pay off old debt with new, "cheaper" debt. Low-interest rates cause risks to be reassessed. If no positive return can be achieved with safe investments, higher risks have to be taken in order to make more profit. This leads to the misallocation of investment money. For example, the prices of shares as well as real estate in selected locations rose in recent years. The cheap money did not primarily seek its way into new productive loans but created asset price bubbles in shares and real estate. The search for real assets as a precaution against inflation continues unabated. Moreover, investments are being financed that would not make economic sense at normal interest rates. These projects only pay off because of the low-interest rates. This prepares the ground for insolvencies and price losses as soon as interest rates rise. States are tempted to abandon their austerity course for budget consolidation and accumulate growing mountains of debt. In addition, the earnings situation of banks and insurance companies deteriorates significantly as a result of low-interest rates, which in turn puts pressure on savings interest rates.


Interest rates could remain very low or even reach a negative level in the next few years. In Europe, a spiral of further growing debt and zero interest rates threatens. The ECB has hardly any leeway left to stimulate economic growth with its monetary policy. It faces the task of ensuring that confidence in monetary stability is not lost.


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