In June of this year, interest rates were reduced for the first time since 2019. This move allowed interest rates to be lowered to 3.75% from the record high of 4% reached in the autumn of 2023.
While this decision by the ECB is welcomed as a relief and may slightly stimulate the economy, businesses still need to be vigilant with their plans for the coming years.
The interest rate reduction was not a surprise. For some time, there had been both talks and indications that interest rates would be reduced. While the reduction provides additional optimism for businesses and consumers, it is essential not to expect interest rates to return to the levels seen five years ago. Several economic circumstances and inflation indicators will dictate the ECB's next steps.
Although many economists predict that we should see at least 1–2 more interest rate cuts this year, if we have interest rates below 3.5% later this year, we can claim that the economic situation is slowly stabilising.
Not everything is dictated by inflation
Positive signs are supported by forecasts of decreasing inflation, economic growth, and rising wages. ECB economists predict 2.5% inflation this year and 2.2% next year. Meanwhile, economic growth is expected to rise to 0.9% this year and 1.4% next year. Last year, wages increased by an average of 3.8%, while they are forecast to grow by 4% this year.
The ECB has repeatedly mentioned the 2% inflation threshold, which would imply the possibility of interest rate cuts. However, the ECB's current move shows that it is keeping a close eye on the situation and is not only looking at the inflation target. The Bank sees that inflation has probably been contained and that a prolonged period of high interest rates could have a negative impact on the economy.
More drastic interest rate cuts could bring back inflation or trigger negative developments such as the appreciation of other currencies against the euro. This would also mean an increase in the prices of imported goods. The current move is therefore measured, but at the same time creates a positive emotional backdrop.
The last few years have been challenging for businesses and residents. It is reflected in a decline in purchasing power. According to the Bank of Lithuania, most of the population started to put their money to use last year, with time deposits increasing from EUR 3 billion to EUR 6.6 billion. As a result, some individuals often give up unnecessary goods and services. All this is an additional hindrance to business.
However, it should not be forgotten that the ECB's reduction in interest rates this summer will eventually reduce the return on fixed-term deposits. This means that some people will look for alternatives to put their money to work or make long-planned purchases. Already reduced mortgage repayments will also contribute to the desire of individuals to live with greater financial freedom.
The projected moderate but positive wage growth should contribute to consumption growth and the recovery of economic activity in Europe over the next two years. The reduction in interest rates will lower the cost of borrowing for small and medium-sized enterprises (SMEs), which comprise around 80% of all businesses.
Reducing interest rates is essential for small and medium-sized enterprises as more affordable loans can support business expansion, innovation and operational efficiency. The ECB's current approach may lead to a short-term increase in economic activity, with small and medium-sized enterprises benefiting from more favourable borrowing conditions.
However, companies must remain vigilant – the broader economic context, including inflationary trends, requires them to consider their strategies for the coming year carefully.
Remarkable Indicators for Lithuania
In the context of EU countries, Lithuania appears very good. Compared to the strongest European countries, the inflation rate in Lithuania (around 1%) is almost three times lower than in Germany (around 3%) or Spain (around 4%).
However, it is essential to remember that the Lithuanian economy depends on other EU countries. Lithuania purchases many products from different countries, so if the cost of producing a particular product in those countries stays the same due to higher inflation, Lithuanians will also not benefit significantly.
This just goes to show that we need to strengthen local business, find solutions that encourage small and medium-sized businesses to grow, and invest in new solutions and technologies to be more competitive.
