Lesson preview · Central banks and interest rates
Central banks and interest rates
~7 min · Free to read
In June 2022, prices in Canada were 8.1% higher than a year before, the biggest rise since January 1983. The Bank of Canada, the country’s central bank, raised its interest rate from 0.25% in early 2022 to 5% by July 2023. Central banks in Australia, the euro area, the UK and the US also raised their rates sharply in 2022 and 2023. By September 2024, inflation in Canada (the yearly rise in prices) was down to 1.6%.
How do dearer loans slow rising prices?
Key Term
Central banks, targets and independence
A central bank looks after the money of a country (or, for the euro, a group of countries) and serves banks and the government. Its main aim is usually low, steady inflation (how fast prices rise on average).
Many central banks have an inflation target, the inflation rate they aim to hit. The Bank of England, the Bank of Canada and the European Central Bank aim for 2% a year. Australia’s central bank aims for 2–3%, steering for the middle, 2.5%.
Often the government sets or agrees the target, and the central bank picks the interest rate itself, without orders from politicians. That freedom is called independence. It is meant to stop politicians cutting rates to win an election and leaving higher inflation for later.
Key Term
The policy rate, and how it sticks
The central bank’s lever is its policy rate, a short-term interest rate it sets (Bank Rate in the UK, the cash rate in Australia).
The money banks keep at the central bank is called reserves. Many central banks pay interest on reserves at or near the policy rate. They also lend to banks that need cash, at a rate close to it. No bank will lend to another for much less than its reserves earn, or borrow for much more than the central bank charges. So other short-term rates stay close to the policy rate, and rates on loans and savings follow.
Some central banks also buy and sell government bonds (loans to the government that the lender can sell on to others). Each central bank uses its own mix of these tools.
One decision changes what loans cost across the economy, and spending and jobs follow. Prices come last: when sales are weak, firms struggle to raise prices and workers to win big pay rises. So a rate rise slows inflation, and a cut supports jobs in a slump.
Key Term
Slow to work
A rate rise does not work at once. Firms finish projects they have already started, and some home loans have fixed rates. This delay is called a time lag. The Bank of England says the full effect can take around 18 to 24 months. So central banks set the rate for where inflation is heading, not where it is.
Trap · Common Misconception
"Higher interest rates push prices up"
Interest is the price of borrowing, so a rise looks like another price rise. But inflation tracks the prices of goods and services. Dearer loans mean people buy fewer of them, so those prices usually rise more slowly.
Slower is not falling. When inflation drops from 6% to 3%, prices still rise, just by 3% a year instead of 6%.
Tip
Monetary or fiscal policy?
Monetary policy is the central bank changing interest rates, and sometimes buying or selling bonds. Fiscal policy is the government changing spending and taxes.
- Who decides: a central bank committee, or the government and lawmakers.
- How fast: a rate committee can act within weeks. A tax or spending change can take months to pass.
- Who feels it: a rate change hits everyone who borrows or saves. A budget can target chosen groups, such as poorer families.
Both take months to reach prices.
Check yourself · no marks
A central bank buys government bonds from banks. It pays by adding to their reserves, the money they keep at the central bank. Will interest rates tend to rise or fall?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Bond buying joins the same chain one step earlier: it lowers interest rates, and spending, output and prices follow. Whatever the tool, find where it enters the chain and follow the chain down.
Practice · 1 / 5
A central bank raises its policy rate from 3% to 4.5%. What usually happens over the next year or two?
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