How Interest Rates Work and Why Central Banks Change Them

How interest rates work: what a central bank actually sets, how the policy rate reaches mortgages, bonds and currencies, why banks raise and cut, what hawkish and dovish mean, and why the statement often moves markets more than the decision.

The interest rate that appears in headlines is the policy rate — the rate a central bank charges or pays on overnight balances with the banking system. Almost every other rate in an economy, from mortgages to government bond yields to what a currency earns overnight, is priced off it. That is why one number, changed by a quarter of a percentage point, moves five asset classes.

Key Takeaways

• The central bank sets one short-term rate. Markets set the rest, priced off it and off expectations of where it goes next.
• Rates are raised to cool inflation and cut to support growth. The trade-off between the two is the whole job.
• Expectations move markets more than decisions. A hike that was fully expected moves nothing; a statement about the next one moves everything.
• "Hawkish" leans toward higher rates; "dovish" toward lower.

What a Central Bank Actually Sets

The policy rate — the Fed funds rate in the US, the deposit rate at the ECB, Bank Rate in the UK — is the rate for overnight money between the central bank and commercial banks. Banks then lend to each other, to companies and to households at rates built on top of it, adding margins for time, risk and profit.

So a 25 basis point (0.25%) change in the policy rate does not directly change a mortgage. It changes the base every lender starts from, and the change propagates over weeks. Long-term rates — the ten-year government bond yield, for example — respond less to the current policy rate and more to where markets expect it to be over the next decade. See what is the yield curve.

Why Banks Raise and Cut

Most central banks have a mandate built around price stability, and some add employment. The lever works in both directions:

• Raise rates when inflation is above target. Borrowing costs more, spending and investment slow, demand cools, price pressure eases. The cost is slower growth and higher unemployment.
• Cut rates when growth is weak or inflation is below target. Borrowing is cheaper, activity picks up. The cost is the risk of overheating and inflation later.

Every decision is a judgement about which risk is larger right now. See what is inflation and what is the Federal Reserve.

How Decisions Are Made and Communicated

Central banks meet on a published schedule, typically every six to eight weeks. Each meeting produces a decision and a statement; most add a press conference and, periodically, projections. Between meetings, officials speak, and minutes are published.

The market prices all of it. By decision day the decision itself is usually priced; what is not priced is the language about the next one. This is why the statement and press conference routinely move markets more than the rate change — see why markets move before economic data is released.

Hawkish and Dovish

A statement can be hawkish while the decision is a hold: "rates unchanged, but the committee stands ready to tighten further" moves the currency up on nothing but the sentence.

Worked Example: How a Hike Travels

The policy rate rises 0.25%.

That last row is why central banks act on forecasts rather than current data: the lever is slow, so the decision has to be made before the problem is visible.

Why It Matters to Traders

Interest rate expectations are the single most consistent driver of currency pairs — capital tracks yield — and a dominant driver of equity valuations and gold. How interest rates affect currencies, stocks, gold and bonds follows one decision through each. On a MarketsAll account, the rate differential between two currencies is also what appears every night as swap.

What is a basis point?

One hundredth of a percentage point. A 25 basis point move is 0.25%.

Why do markets sometimes fall when rates are cut?

Because a cut can signal that the central bank sees weakness the market had not fully priced. The information in the decision can outweigh the decision.

What does "higher for longer" mean?

Holding the policy rate at its current level for an extended period rather than cutting. It is hawkish guidance without a hike.

How often do central banks change rates?

Meetings are typically six to eight weeks apart. Changes happen at some meetings and not others; the schedule is published a year ahead.

Do interest rates affect gold?

Strongly. Gold pays no yield, so it competes with the after-inflation return on cash. Rising real rates tend to weigh on it.

Related Reading

What is inflation · What is the Federal Reserve · What is the yield curve · How interest rates affect markets · Swap