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Do central banks set interest rates, or do markets?

24 September 2022 (latest revision: 28 April 2023)

Ara Economicus
Ara Economicus

How central banks influence interest rates

From time to time, financial news outlets discuss central banks' decisions on interest rates. On the other hand, economists claim markets determine interest rates based on the supply and demand of funds. But central banks influence interest rates and the available funds. The standard explanation is that central banks set short-term interest rates based on their estimates of the economy and inflation. By doing so, they influence long-term interest rates via financial markets.

It works as follows. Based on estimates of future short-term central bank interest rates, financial institutions borrow short-term to buy longer-term government bonds. For instance, if traders expect the short-term interest rate will remain below 2% in the coming year and 1-year government bonds yield 3%, they may borrow short-term money from the central bank to buy these bonds and pay them back when they mature and pocket the 1% difference.

This trade creates demand for these bonds, so their price rises and their yield drops. Perhaps, traders stop buying the bond when the interest rate on the bond drops to 2.5% because there is always a risk that the central bank will raise interest rates. If 10-year bonds yield 4%, another trader might sell 1-year bonds he might not own and invest the proceeds in 10-year bonds, bringing down their yield too. Usually, this happens in the futures markets.

If traders in financial markets believe that the central bank will raise interest rates, they sell bonds, so their prices go down, and their yields rise until bond yields reflect the expected interest rate hike. Central banks have stated goals concerning inflation and sometimes economic growth and unemployment. Inflation, GDP, and unemployment numbers tell traders much about what central banks will do. So, if unemployment rises, interest rates might fall.

The financial markets are supposed to discipline central banks. Traders in financial markets might believe a central bank is doing a poor job. For instance, if inflation increases or the government runs growing deficits, and the central bank doesn't sufficiently raise interest rates, the value of its currency could drop, and inflation could spiral out of control. To prevent that, the central bank may have to raise interest rates to protect the currency and prevent inflation.

Altering markets

Opponents of central banks argue that central banks eliminate the market mechanism. The interventions of central banks profoundly affect how financial markets operate. As a result, there is much more lending than there otherwise would have been. Central banks create liquidity in financial markets. Banks can buy and sell government bonds with different maturities to match their lending, making all types of lending and borrowing are possible at any time.

In the past, the situation was different. Banks had to be careful not to run into trouble because they could not borrow easily at the central bank. For instance, if you applied for a mortgage, the bank tried to find matching term deposits. Perhaps, you could get a 5-year mortgage if the bank had sufficient 5-year deposits. After five years, you had to renew your mortgage, and if the bank lacked deposits, you could not renew it and had to sell your home.

Central banks reduce the risk of bank failures. For instance, when borrowers pay back their debts, banks are solvent, but they may find themselves short of cash when depositors take out their deposits. Central banks can create this cash if needed so banks need less cash. Central banks can also rescue banks and reduce te risk to the general economy. After all, a financial crisis can cause an economic crisis like the Great Depression. That nearly happened in 2008.

One can argue that central banks subsidise the financial sector in the following ways:
  • Central banks reduce the risk of systemic failure so financial institutions can take more risk and lend more. Banks may make risky loans to profit from higher interest rates if they expect the central bank will help them if it goes wrong.
  • Central banks signal their intentions to financial markets. If the central bank intends to change interest rates, it gives an advance notice so financial institutions are not caught off-guard and can adapt their bond portfolios and borrowing.

  • The supply and demand of funds in financial markets ultimately determine interest rates. But without central banks, financial markets operate differently, and there would be far less borrowing and lending. And because central banks allow the financial system to function more smoothly and reduce the risk of systemic failure, interest rates might be lower than they would have been otherwise. That can benefit society.
  • Many people see central banks as powerful undemocratic technocratic institutions. Central banks have become more independent from the governments since the 1970s because governments used them to finance their spending via money printing, leading to inflation.
  • Others believe central banks impede the correct functioning of financial markets by mispricing risk. Without central banks there would be less lending and borrowing because financial institutions have to be more careful. Bank failures would occur more often, and banks would pay more interest to depositors to compensate for that risk.

  • Conclusion

    Central banks set short-term interest rates and profoundly affect long-term interest rates. The actions of central banks also make a lot more lending and borrowing possible by providing liquidity to financial institutions via government bond trading. Ultimately, markets determine interest rates. When the central bank loses its credibility of fighting inflation, investors sell the currency and the value of the currency will drop. This happened, for instance, in Turkey.

    The need for central banks is partly the consequence of interest charges on money and debts. It is explained in the blog post Saving the economy and restoring financial sanity. Nowadays, most money is debt. Banks loan money into existence, and debtors must repay it with interest. If the interest rate is 5%, and banks have loaned € 100, they expect € 105 in return. That money is not there and may need to created by the central bank to prevent a crisis.