How do central banks impact interest rates in the economy?

Monetary policy consists of the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).

Broadly, there are two types of monetary policy, expansionary and contractionary. Expansionary monetary policy increases the money supply in order to lower unemployment, boost private-sector borrowing and consumer spending, and stimulate economic growth. Often referred to as "easy monetary policy," this description applies to many central banks since the 2008 financial crisis, as interest rates have been low and in many cases near zero. 

Contractionary monetary policy slows the rate of growth in the money supply or outright decreases the money supply in order to control inflation; while sometimes necessary, contractionary monetary policy can slow economic growth, increase unemployment and depress borrowing and spending by consumers and businesses. An example would be the Federal Reserve's intervention in the early 1980s: in order to curb inflation of nearly 15%, the Fed raised its benchmark interest rate to 20%. This hike resulted in a recession, but did keep spiraling inflation in check.

Central banks use a number of tools to shape monetary policy. Open market operations directly affect the money supply through buying short-term government bonds (to expand money supply) or selling them (to contract it). Benchmark interest rates, such as the LIBOR​ and the Fed funds rate, affect the demand for money by raising or lowering the cost to borrow—in essence, money's price. When borrowing is cheap, firms will take on more debt to invest in hiring and expansion; consumers will make larger, long-term purchases with cheap credit; and savers will have more incentive to invest their money in stocks or other assets, rather than earn very little—and perhaps lose money in real terms—through savings accounts. Policy makers also manage risk in the banking system by mandating the reserves that banks must keep on hand. Higher reserve requirements put a damper on lending and rein in inflation.

In recent years, unconventional monetary policy has become more common. This category includes quantitative easing, the purchase of varying financial assets from commercial banks. In the US, the Fed loaded its balance sheet with trillions of dollars in Treasury notes and mortgage-backed securities between 2008 and 2013. The Bank of England, the European Central Bank and the Bank of Japan have pursued similar policies. The effect of quantitative easing is to raise the price of securities, therefore lowering their yields, as well as to increase total money supply. Credit easing is a related unconventional monetary policy tool, involving the purchase of private-sector assets to boost liquidity. Finally, signaling is the use of public communication to ease markets' worries about policy changes: for example, a promise not to raise interest rates for a given number of quarters.

Central banks are often, at least in theory, independent from other policy makers. This is the case with the Federal Reserve and Congress, reflecting the separation of monetary policy from fiscal policy. The latter refers to taxes and government borrowing and spending.

Essentially, the term “interest rates” stands for a monetary compensation, usually expressed in a percentage per annum. The lender of the fiscal amount is compensated for the loss that he or she suffers – the owner of the money may invest them and thus generate income instead of lending funds to the borrower. One of the ways a central bank (or a reserve bank or other monetary authority) may control interest rates is by open market operations. A central bank may indirectly intervene in the economy of its country or union of states by buying government securities. By purchases, the bank raises the price of the securities on the open market, thus lowering their rates and the interest rates in general. The interest rates may be modified directly by the respective monetary institution, as well. After all, interest rates are just tools of monetary policy and may be used to curb variables like investment and inflation. Historically speaking, interest rates have been governed by national governments orcentral banks. The Fed’s federal funds rate in the US has fluctuated from 0.25% to 19% for the period between 1954 and 2008. Variations in the base rate of the Bank of England from 1989 to 2009 measured from lowest 0.5% to a high of 15%. But for the layman’s mind, it is noteworthy to point out that the generally referred to (in media) as interest rate is the annualized rate offered by a respective central bank on overnight deposits. As a matter of fact, there are some authors such as Daniel L. Thornton, from Federal Reserve Bank of St. Louis, who argue that “it is money that matters and interest rates does not”, due to the perceived virtuality of the interbank interest rates. Further Thornton points out that monetary policy is at present conducted by targeting short-term interest rates. The banking authorities undertake to manage the price level by manipulating aggregate demand while fixing their targeted interest rate. So, the aforementioned author claims that money’s role is at best tertiary. Even more, the author points out that according to some other renowned economists, money is probably irrelevant in the determination of the price level. But the author of the working paper argues against these macroeconomists, claiming that the most prominent feature of money is its ability to warrant “final payment”. He also suggests that the central banks’ ability to control interest rates may be overtly exaggerated. The author reports that according to Friedman (1999) “a widely shared opinion today is that central banks need not actually do anything. With a clear enough statement of intentions, ‘the markets will do all of the work for them’ as far as controlling the funds rates in view of the target for the funds rate is concerned (funds rate = the interest rate at which a depository institution lends available funds straightforward to another depository for the overnight). The author further clarifies the EH (expectations hypothesis), stating that “a longer-term rate is equal to the average of the current and expected future short-term rate”. Then, he concludes that this hypothesis would mean, if true, that all rates would be linked with the overnight rate; but the aforementioned hypothesis has been proven wrong numerous times by authors such as Campbell and Shiller, Cochrane and Piazzesi, and Thornton himself. The apparent erroneousness of the EH proposition gives ground to deeply doubt FED's means of controlling the interest rates by applying the apparatus of the expectations hypothesis. 

The most influential economics tool the central bank has under its control is the ability to increase or decrease the discount rate. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing.

For banks and depository institutions, the discount rate is the interest rate assessed on short-term loans acquired from regional central banks. Financing received through Fed lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution; as such, loans are extended only for an overnight term. The discount rate can be interpreted as the cost of borrowing from the Fed.

When the Fed makes a change to the discount rate, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the Federal Reserve may enact its power to reduce the discount rate in an effort to make borrowing more affordable for member banks.

When banks can borrow funds from the Fed at a less expensive rate, they are able to pass savings on to banking customers through lower interest rates charged on personal, auto or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending during the time in which rates are low.

Although a reduction in the discount rate positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction to interest rates on savings vehicles as well. This may discourage long-term savings in safe investment options such as certificates of deposit (CDs) or money market savings accounts.

When the economy is growing at a rate that may lead to hyperinflation, the Fed may increase the discount rate. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase to the discount rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this tactic is implemented. Although lending is not as attractive to banks or consumers when the discount rate is increased, consumers are more likely to receive more attractive interest rates on low-risk savings vehicles when this strategy is set in motion.

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