What the central bank does when it changes interest rates

Central banks are usually in the news for one decision: whether to raise, lower or hold their policy interest rate. The decision itself is simple. What follows from it is not.

What the policy rate is

Commercial banks hold accounts at the central bank, and the balances in those accounts are called reserves. Banks lend reserves to each other overnight to manage their daily positions. The policy rate is the rate the central bank sets, or targets, for that overnight lending. It does this either by paying interest on reserves, by lending to banks at a set rate, or by buying and selling securities to adjust the amount of reserves in the system.

Because the overnight rate is the cheapest and shortest form of borrowing, every other interest rate in the economy is built on top of it. A bank deciding what to charge for a mortgage starts from what it costs to fund the loan, and that cost starts from the policy rate.

How a change travels

When the central bank raises the policy rate, the effect moves through several channels.

The first is direct borrowing costs. Floating-rate loans, overdrafts and many business loans reprice within weeks. Fixed-rate mortgages and bonds reprice only when they are renewed or issued, so the effect on those builds gradually over years as old loans mature.

The second is asset prices. Higher rates reduce the present value of future income, which tends to lower share and property prices. Households and firms that feel less wealthy spend less.

The third is the currency. Higher rates attract foreign capital, which strengthens the currency, making imports cheaper and exports less competitive. That lowers inflation through import prices and reduces demand for domestic production.

The fourth is expectations. If businesses and households believe the central bank will keep inflation low, they set prices and wages accordingly, and that belief does much of the work on its own. Central banks spend a great deal of effort on communication for this reason.

Together these channels reduce demand, which eases pressure on prices and, eventually, on wages. A rate cut works in reverse. The full effect takes between one and two years to arrive, which is why central banks act on forecasts rather than waiting for inflation to appear.

What the central bank is trying to do

Most central banks have a mandate to keep inflation at a target, commonly two per cent a year. Some have a second objective, such as maximum sustainable employment, and all pay attention to financial stability. When inflation is above target, the bank raises rates to slow demand. When it is below target or the economy is weakening, it cuts.

The difficulty is that the bank cannot see the future and the tool is blunt. Raise rates too far and the economy contracts more than needed; raise too little and inflation becomes entrenched. Policymakers use forecasts, surveys and financial-market signals to judge, and they revise as data arrive.

Beyond the policy rate

When the policy rate is already near zero, central banks have used other tools. Buying government bonds, known as quantitative easing, pushes down longer-term yields directly. Forward guidance, a commitment about the future path of rates, works through expectations. Selling bonds or letting them mature, quantitative tightening, reverses the first.

Reading a decision

A rate decision comes with a statement, often a press conference, and periodically a set of forecasts. Markets react to the guidance about future decisions at least as much as to the decision itself. A cut accompanied by a warning that further cuts are unlikely can tighten financial conditions; a hold accompanied by a hint of easing ahead can loosen them. The number is the headline. The path is the story.

This guide is general information, not investment advice.