Published January 13, 2015
The European Central Bank influences the cost of borrowing in the economy of the 17-country eurozone by moving its key interest rate up and down.
Its main refinancing rate is the rate at which eurozone banks can borrow from the ECB. That affects the rate at which banks borrow from each other, the so called money-market rates.
Based on these rates, the banks then decide how much to charge consumers and businesses for loans and how much to pay on deposits.
Here's how ECB rate cuts can affect households, companies and markets:
Companies are affected by interest rate cuts in the same way as households. When taking out loans becomes cheaper, a company is more likely to spend and invest.
Small and medium-sized companies would feel the impact of a rate cut the most, since they depend on bank loans more than large corporations which can raise money by issuing corporate bonds.
One of the reasons that the eurozone economy is doing so poorly is that the smaller companies are struggling to get loans at affordable rates. They form the backbone of the European economy, so improving their performance is key to the continent's hopes of emerging from recession.
By lowering its key rate, the ECB hopes companies will invest in new jobs, which will help boosting consumer spending and the economy.
A rate cut should lead to lower costs for borrowing for consumers — both through cash loans and using credit cards — and in cheaper mortgage rates.
It also means that stashing money away in a savings account would yield less. That might encourage a saver to invest their money where returns are better. That investment, in turn, helps the economy.
However, a rate cut is not guaranteed to send people out to the shops. Some households are currently wary of spending because they are afraid they might lose their jobs — unemployment is at a record 12.1 percent in the eurozone. Others have seen their income reduced after governments in some countries have cut public-sector salaries and trimmed pension payments.
An ECB rate cut typically boosts the stock market and hurts the currency, in this case the euro.
Stocks rise as investors bet that the cheaper borrowing rates will feed through to households and companies, boosting economic activity. The hope is that results in higher earnings for the companies whose shares the investors buy.
The euro would be weakened because the ECB's rate cut lowers the amount of interest that investors can earn from interest-bearing investments in that currency. A savings account, for example, will yield a lower rate of return.
Experts say that when central banks set their key interest rates at ultra-low levels — as is the case in the eurozone, the U.S., Japan and Britain — some investors borrow money cheaply to make speculative bets. That can cause surprisingly strong gains in some investments, such as stock or commodities. Some analysts say that is one reason the stock market has done so well this year, despite weak economic growth.