Interest rates – frequently asked questions (FAQ)

Changing interest rates is the main tool that central banks have for affecting demand and activity in the economy. Raising interest rates makes it more expensive to borrow, and so fewer goods and services are bought. This then eases price pressures. Cutting interest rates when the economy is in recession makes borrowing cheaper though, and the money that is borrowed can revive the economy by encouraging purchases of goods and services and supporting investment. Raising interest rates has the most impact on the parts of the economy where borrowed money is used more, such as the real estate market or purchases of expensive items like cars that are funded with loans.

Central bank interest rates were very low for a very long time after the global financial crisis, and in some places they were even negative. At the same time central banks injected new money into the economy, in effect printing money, by buying securities from investors. This is unusual, but was done because inflation had fallen to a dangerously low level in the economy. Inflation being too low is a problem for the economy, as it eventually causes unemployment to rise.

The time when central bank interest rates were very low and the central banks were printing money ended as the economy recovered faster than expected from the removal of the COVID-19 pandemic restrictions.

EURIBOR is the interest rate that is set in the interbank money market and shows the price at which the largest banks in Europe are ready to lend money to one another.

The central bank does not decide the level for euribor, but the monetary policy interest rates of the central bank affect how it is set. The commercial banks can borrow and deposit money with the central bank instead of the money market, and so the basis for setting the money market interest rate, or EURIBOR, is what central bank monetary policy interest rates are expected to be.

EURIBOR, especially the six-month EURIBOR, is used as the base interest rate for loans in Estonia. A risk margin is added on top of EURIBOR, which gives the bank additional security if the borrower is not able to pay off their debt. The risk is different for each client, and so the risk margins of the clients are also different.

Having been very low for a long time, and even negative for several years, the six-month EURIBOR went past zero in spring 2022 and had climbed above 3.7% by early June 2023. That is not an extraordinarily high level for interest rates in historical terms, and in the longer term it could generally be considered a normal rate.

Monetary policy needs to make sure that high inflation does not take root in the economy and that it comes down as fast as possible. Intervening early by raising interest rates makes it less likely that they will need to be raised even further later on.

Keeping inflation expectations from rising and becoming fixed above 2% requires decisive reactions. The rise in the key interest rates of the European Central Bank since July 2022 has been the fastest since the euro was introduced. Interest rates have been raised with the goal of keeping inflation in the euro area at 2%. See the answer to the question below of why the European Central Bank’s inflation target is 2%.

It is too early and too risky to assume that the decline in economic activity will by itself pull inflation down, especially given that lower energy prices have helped economic activity increase and that the outlook for the economy has improved. It may seem counter-intuitive, but the current strict monetary policy of higher interest rates will help keep loan repayments from being much bigger in the future. If central banks hesitated in raising interest rates now, then they would probably have to raise them even higher in the future to tackle inflation.

Only once inflation has been brought under control can people’s purchasing power start to increase again, and businesses gain the confidence to make investments and create jobs. The purchasing power of wages will also recover over time, but if that happens too fast, the result is that labour costs are high, which makes exporting companies less competitive. Companies being less competitive leads unemployment to rise and so there is a permanent fall in the amount of work done within the whole of society. Purchasing power falling because inflation is high and then taking some years to recover is the price that society pays for employment being as high as possible and the largest possible number of people keeping their jobs even when the economy is adjusting to new price levels.  

Higher interest rates mean larger loan payments for housing loans.

EURIBOR rising from 0% to 3% increases the monthly payment of the average housing loan with around 50,000 euros outstanding by about 75 euros, or 4.5% of net income for a single borrower. The monthly payment for a loan taken in recent years with around 100,000 euros outstanding would be increased by a rise in Euribor by 150 euros, or 9% of net income for a single borrower. The loan repayment is a smaller share of income when there is a second borrower.

Higher interest rates have less of an impact on whether borrowers can cope than the general rise in the cost of living and energy prices does. The greatest risk that higher interest rates pose to someone’s ability to cope comes if they lose their job. Problems in coping with loan payments can be eased by negotiations between the bank and the borrower.

Eesti Pank requires that the commercial banks assess the ability of a borrower to pay their housing loan if interest rates rise to 6%, meaning a margin of 2% and EURIBOR at around 4%. This has reduced the danger of rising interest rates creating a lot of difficulties for people in paying their loans. Eesti Pank’s modelling shows that higher interest rates, with EURIBOR rising to 6% or more, would not substantially increase the number of people facing troubles with their loan repayments.

Borrowers in Estonia mainly have an income that is above the average, by around 30%. This suggests that borrowers are generally better able to cope than other parts of society despite interest rates rising. Only 0.2% of loans in Estonia are overdue by more than 60 days, which is a historically very low level.

Floating interest rates have been a good option when interest rates were unusually low. Borrowers looking for more certainty about their future loan payments are able to fix their interest rate for some time ahead, though a fixed interest rate generally means a higher rate than the floating EURIBOR rate at the time of fixing. The interest rate is higher at the moment that it is fixed because the bank offering it to the client calculates how interest rates may move. It is not financially reasonable for the bank to offer clients a loan at a cheaper rate than what the bank itself can borrow from the market at, since that would mean that the bank would be paying the client to borrow from it.

Deposit interest rates react with some delay to both rises and falls in interest rates, depending on the length of the contract.

Deposit interest rates can vary between banks depending on how the banks finance their own activities, meaning how much capital they get from bond markets and how much they need to use deposits for financing. The biggest banks in Estonia are well capitalised and have liquidity, so those banks have less need for deposits than the smaller banks, which have smaller capital buffers and stocks of liquidity, meaning available money. The small banks consequently often offer higher interest rates for deposits.

A key factor in setting deposit interest rates is the level of economic activity and the consequent demand for loans, together with the degree of competition between the banks. In response to the European Central Bank raising interest rates and with the fast-growing smaller banks taking the lead, the interest rate on term deposits in Estonia has risen.

Rising deposit interest rates makes it sensible to hold available money in a term deposit, as that earns a higher rate of interest. Holding money simply on a current account as a demand deposit pays minimal interest.

The main tool available to the central bank for restraining inflation is interest rates, which by their nature should cool the economy and so stop prices rising. High inflation is harmful for the economy and for society as a whole, and in the long-term high inflation is a bigger problem for the finances of people and businesses than the larger loan payments that are the consequence of higher interest rates. If high inflation should gain deep roots within the economy, it may become necessary to raise interest rates even higher. The efforts to escape from high inflation can however lead to short-term losses in the economy by causing a recession or increasing unemployment.

The law defines maintaining price stability with inflation low and stable as the most important task of all the central banks in the euro area, including the European Central Bank and Eesti Pank. This key legal requirement must be considered when decisions are taken, because if inflation becomes too high in the euro area, the euro area central banks will have to react to that and start to rein it in.

Borrowing becoming more expensive has reduced the demand to buy real estate, which has put an end to the rapid growth in real estate prices.

Eesti Pank believes that overall it would be good if the real estate market were to calm down after its boom in 2021–2022. Real estate prices rising rapidly meant that real estate was overvalued, and people became less able to afford it.

Eesti Pank does not see any major solvency problems in May 2023. Repaying a mortgage has become a serious problem for one borrower in 800 on average. The number of people and businesses facing difficulties in repaying their loans may rise somewhat in future, but they will remain a small share of the total.

Eesti Pank does not see any broader danger to the Estonian financial system from the rises in interest rates. The banks are well capitalised and they have followed the requirement of the central bank in issuing loans that the borrower must be able to manage their loan repayments even with an interest rate of 6%.

Higher interest rates have the biggest impact in sectors where financial leverage is high and interest is a large part of expenses, such as energy, real estate, and agriculture and forestry.

Higher interest rates make it more expensive for companies to borrow funds, which can mean they have to adapt their business models and review their investment plans. Companies in Estonia are generally in a good position financially, and the current rate of interest rates should not be too much for them to cope with. As uncertainty about the economy and the future trajectory of interest rates fades, companies will probably again become braver than they are now when investing and borrowing.

The rising cost of loans together with high inflation reduces the purchasing power of consumers, and so also their demand for goods and services. 

A rise in key interest rates also makes it more expensive for the government to borrow.

It is reasonable to borrow during a crisis to offset the negative impacts, but forecasts in Estonia find that state revenues and expenditures have moved out of balance. The money that is spent on interest payments is unavailable to the budget for other activities, and a growing state debt makes it harder to tackle other crises in the future.

The Estonian state debt was 2.5 billion euros before the pandemic, which was 8–9% of GDP, but in the first half of 2023 it was around 6.5 billion, or some 18% of GDP. The debt is forecast to grow and reach 11.5 billion euros in a few years, or 26% of GDP. The larger debt burden combined with the changing geopolitical risks caused by the war in Ukraine have resulted in larger interest expenses. Estonia spent 8 million euros on paying the interest on the state debt in 2021, but in a couple of years from now it could be spending 240 million euros.

If the general government budget deficit remains at 3%, the Estonian debt burden will double in the next decade. An interest rate of 4% would then mean the state paying the same amount each year in interest payments as it spends on the police and the rescue board. A larger debt burden is unfortunately not just a temporary and one-off event, but is a permanent annual expense that leaves a smaller share of tax revenues for the day-to-day spending of the state.

The rise in key interest rates is mainly passed on to households and companies through the banks.

Banks make larger profits than usual because the interest rates on loans and deposits change at different speeds. Changes in loan interest rates reach Estonia within half a year because most loans use the six-month EURIBOR as their reference rate, but changes in deposit rates arrive much more slowly. In the opposite case, where interest rates drop rapidly, the banks face a loss or earn only a very small profit.

The role of banking in society is like circulating the blood of the economy by financing the activities of people and businesses. For it to function properly, the banks need to put aside a sufficient part of the capital earned as profits during the good times, and be restrained in paying out dividends. This means the banks then have buffers if there is a crisis in the economy so they can cover their losses and continue to finance the economy during difficult times. If the banks do not put sufficient capital aside, they will find it harder to deal with bad loans in a crisis, meaning they have less available for new lending and so cannot help the economy recover.

The banks were also earning larger profits than usual before the economic crisis of 2009, and they put a lot of that aside as capital. This meant they were able to cover the loan losses caused by the crisis and could very successfully fund the rapid recovery of the Estonian economy from 2010.

The clients of the banks need to be proactive and demanding and to look at the competing offers from different banks when taking new loans, refinancing existing loans, or making deposits.

There have already been signs of interest rates rising for term deposits, and of loan margins narrowing.

Inflation in the euro area reached a record high in October 2022. It has fallen since then primarily because the prices of energy and fuels have come down, and the supply problems caused by the pandemic have lessened. A further factor is the high reference base because prices were higher a year ago. Inflation in the euro area still remains a long way above 2%, which is the target of the European Central Bank.

A key consideration is that core inflation is quite far from 2%. Core inflation measures inflation without the very volatile prices of energy and food. Core inflation remaining high shows that inflation in the economy more broadly has not started to come down. Core inflation is affected when companies pass higher prices for inputs into the end prices for their products, or plan to do so. How high inflation affects wage rises, and consequently inflation, is also very important. Central banks monitor core inflation because it is the permanent price pressures which appear there that the central bank is most able to affect with its monetary policy of changing interest rates and the price of borrowing.

The central bank cannot cut interest rates until it is convinced that inflation is definitely coming down to 2%. The current headline figure for inflation is not on its own enough, as various trends need to be analysed, including inflation expectations and wage demands, and the impact of decisions already taken must be considered.

The European Central Bank adjusts its interest rates in response to what is happening in the economy, and especially to how high inflation is. Interest rates must rise until the bank can be certain that inflation is moving permanently towards the target level of 2%, and even then it is best to assume that interest rates will remain for some time at the level they have risen to, and not to expect any immediate cut in rates.

The key target of the European Central Bank, and all the other central banks in the euro area, is to keep inflation in the euro area at around 2% over the medium term perspective of one or two years.

Economists believe the target of 2% is appropriate because:

1) it allows businesses, people and governments to make long-term plans about when to borrow and when to save;

2) it is high enough above zero, which is when prices on average do not change at all. Long periods of generally falling prices could easily lead to a downward spiral in them as people start to delay making purchases in the hope that prices will be even lower in the future. This would lead them to spend less and buy less, meaning less is produced and consequently a lot of people are left without a job.

It is important to note that the target has a perspective of one or two years, which means that the European Central Bank does not make its decisions about interest rates by looking only at the latest figures for inflation. The central bank is aiming to set interest rates and take other steps so that inflation would be 2% after a year or two. This forward-looking approach is taken because the full impact of the measures taken by the central bank when it makes the price of borrowing higher or lower only reaches the economy after some delay.

The total impact of the interest rate decisions taken by the central bank will not move inflation immediately, but after some delay. Higher interest rates have their main impact after one or two years.

Forecasts change all the time, as the external factors that steer inflation such as the prices of oil and other commodities have been extraordinarily volatile in the past decade. The European Central Bank forecast in March 2023 that inflation will approach 2% in 2025.