Editing Monetary policy (section)

=== Key interest rates ===

[[File:Federal_Open_Market_Committee_(FOMC)_in_Washington_DC_April_26-27,_2016.jpg|thumb|375x375px|2016 meeting of the Federal Open Market Committee at the [[Eccles Building]], Washington, D.C.]]
For most central banks in advanced economies, their main monetary policy instrument is a short-term interest rate.<ref name=RBA>{{cite web |last1=Baker |first1=Nick |last2=Rafter |first2=Sally |title=An International Perspective on Monetary Policy Implementation Systems {{!}} Bulletin – June 2022 |url=https://www.rba.gov.au/publications/bulletin/2022/jun/an-international-perspective-on-monetary-policy-implementation-systems.html |publisher=Reserve Bank of Australia |access-date=13 August 2023 |language=en-AU |date=16 June 2022}}</ref> For monetary policy frameworks operating under an exchange rate anchor, adjusting interest rates are, together with direct intervention in the [[foreign exchange market]] (i.e. open market operations), important tools to maintain the desired exchange rate.<ref>{{cite web |title=Fixed exchange rate policy |url=https://www.nationalbanken.dk/en/frequently-asked-questions/fixed-exchange-rate-policy |website=Nationalbanken |access-date=13 August 2023 |language=en}}</ref> For central banks targeting inflation directly, adjusting interest rates are crucial for the [[monetary transmission mechanism]] which ultimately affects inflation. Changes in the central bank policy rates normally affect the interest rates that banks and other lenders charge on loans to firms and households.

Higher interest rates reduce inflation by reducing aggregate [[Consumption (economics)|consumption]] of goods and services by several causal paths.<ref>{{cite web |url=https://www.employamerica.org/researchreports/how-the-fed-affects-inflation/ |date=February 9, 2022 |author1=Skanda Amarnath |author2=Alex Williams |title=What Are You Expecting? How The Fed Slows Down Inflation Through The Labor Market}}</ref> Higher borrowing costs can cause a cash shortage for companies, which then reduce direct spending on goods and services to reduce costs. They also tend to reduce spending on labor, which in turn reduces household income and then household spending on goods and services. Interest rate changes also affect [[asset prices]] like [[stock price]]s and [[Real estate appraisal|house prices]]. Though unless they are selling or taking out new loans their cash flow is unaffected, asset owners feel less wealthy (the [[wealth effect]]) and reduce spending.

Rising interest rates also have smaller secondary effects, which decrease supply and tend to increase inflation (or cause it to decrease more slowly than it otherwise would. On the individual side, rising mortgage rates disincentivize wealthy homeowners from downsizing or moving to a new home if they have an existing mortgage that is locked in at a low fixed rate.<ref>{{cite news |url=https://www.marketplace.org/2024/02/19/housing-market-mortgage-rates-inventory/ |date=February 19, 2024 |publisher=Marketplace |title=High mortgage rates, low inventory keep the housing market tight |author=Mitchell Hartman}}</ref> On the business side, lower investment and spending may result in lower supply of new homes and other goods and services.

Firms experiencing high borrowing costs are also less willing or able to borrow or spend money on [[investment]] in new or expanding business. International interest rate differentials also affect exchange rates, and consequently [[exports]] and [[imports]]. Consumption, investment, and net [[exports]] are all important components of aggregate demand. Stimulating or suppressing the [[aggregate demand|overall demand]] for goods and services in the economy will tend to increase respectively diminish inflation.<ref name="Fed goals II">{{cite web |title=Federal Reserve Board - Monetary Policy: What Are Its Goals? How Does It Work? |url=https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm |website=Board of Governors of the Federal Reserve System |access-date=13 August 2023 |language=en |date=29 July 2021}}</ref>

The concrete implementation mechanism used to adjust short-term interest rates differs from central bank to central bank.<ref>{{cite book |title=MC Compendium Monetary policy frameworks and central bank market operations |date=October 2019 |publisher=Bank for International Settlements |isbn=978-92-9259-298-1 |url=https://www.bis.org/publ/mc_compendium.pdf}}</ref> The "policy rate" itself, i.e. the main interest rate which the central bank uses to communicate its policy, may be either an administered rate (i.e. set directly by the central bank) or a market interest rate which the central bank influences only indirectly.<ref name=RBA/> By setting administered rates that commercial banks and possibly other financial institutions will receive for their deposits in the central bank, respectively pay for loans from the central bank, the central monetary authority can create a band (or "corridor") within which market interbank short-term interest rates will typically move. Depending on the specific details, the resulting specific market interest rate may either be created by open market operations by the central bank (a so-called "corridor system") or in practice equal the administered rate (a "floor system", practiced by the Federal Reserve<ref>{{cite web |last1=Ihrig |first1=Jane |last2=Wolla |first2=Scott A. |title=The Fed's New Monetary Policy Tools |url=https://research.stlouisfed.org/publications/page1-econ/2020/08/03/the-feds-new-monetary-policy-tools |website=research.stlouisfed.org |publisher=Federal Reserve Bank of St. Louis |access-date=13 August 2023 |language=en |date=August 2020}}</ref> among others).<ref name=RBA/><ref>{{cite web |last1=Whelan |first1=Karl |title=International Money and Banking: 8. How Central Banks Set Interest Rates |url=https://www.karlwhelan.com/IMB/part8.pdf |website=www.karlwhelan.com |date=Spring 2020}}</ref>

As an example of how this functions, the [[Bank of Canada]] sets a target [[overnight rate]], and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited.<ref>Bank of Canada backgrounders: [https://www.bankofcanada.ca/wp-content/uploads/2010/11/target_overnight_rate_jan2016.pdf.pdf Target for the Overnight Rate]</ref>
[[File:10-year_minus_3-month_US_Treasury_Yields.png|right|thumb|400x400px|Yield curve becomes inverted when short-term rates exceed long-term rates.]]The target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of [[inverted yield curve]]s, even below the short-term rate.

Many central banks have one primary "headline" rate that is quoted as the "central bank rate". In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced. A typical central bank consequently has several interest rates or monetary policy tools it can use to influence markets.

* [[Discount window|Marginal lending rate]] – a fixed rate for institutions to borrow money from the central bank. (In the United States, this is called the [[Discount window|discount rate]]).
* Main refinancing rate – the publicly visible interest rate the central bank announces. It is also known as ''minimum bid rate'' and serves as a bidding floor for refinancing loans. (In the United States, this is called the [[federal funds rate]]).
* Deposit rate, generally consisting of interest on reserves – the rates parties receive for deposits at the central bank.