the plan for the future

Do central banks set interest rates, or do markets?

24 September 2022

Ara Economicus
Ara Economicus

From time to time, financial news outlets discuss central banks decisions on interest rates. A question is whether central banks determine interest rates or that markets them. The standard explanation is that central banks set short-term interest 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 their assessment of future short-term interest rates set by the central bank, financial institutions borrow money 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 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 investment has gone down to 2.5%, because there is always a risk that the central bank will raise interest rates. If 10-bonds yield 4%, another trader might sell his 1-year bonds and invest the proceeds in the 10-year, bringing their yield down too.

It depends on what traders expect. Central banks usually have goals concerning inflation and sometimes economic growth and unemployment. Inflation, GDP, and employment numbers often tell a great deal about what central banks will do. Even the expectation of inflation and the anticipated future response of the central bank affects interest rates. For instance, when the British Prime Minister announced a massive spending plan yesterday, interest rates on the British Pound rose. Traders expected that the Bank of England would have a more difficult task combating inflation and must raise interest further then previously thought.

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. The interventions of central banks affect how financial markets operate. Central banks create liquidity in financial markets, which means that all types of lending and borrowing are possible at any time, which helps the economy to function smoothly.

Before there were central banks, the situation was different. Banks had to be careful not to run into trouble because they could not borrow at the central bank. For instance, if you applied for a mortgage, the bank tried to find matching term deposits. And so, 30-year mortgages were hard to come by because few depositors were willing to lend their money for 30 years. Perhaps, you could get a 5-year mortgage if the bank had sufficient 5-year deposits. But, after five years, you had to renew your mortgage, and if the bank lacked deposits, you could not get a new mortgage 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 still find themselves short of cash when depositors take out their deposits. Central banks can create this cash and lend it to the banks until the borrowers repay their debts. In doing so, they reduce te risk to the general economy. If a bank fails, money disappears, and more debtors cannot meet their obligations, so more banks may fail. It can lead to a financial crash and, subsequently, an economic crisis like the Great Depression. That nearly happened in 2008.

Financial markets with central banks are different from financial markets without central banks. Central banks reduce the risk of bank failures and liquidity risk so that the terms of loans do not have to match those of the deposits. For instance, the financial system can now finance 30-year mortgages from demand deposits. But central banks are also a boon to the financial sector.

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. It can cause moral hazard. For instance, banks may make risky loans at high interest rates to make more profit if they expect the central bank will help them if things go wrong.
  • Central banks signal their intentions to financial markets. It helps financial institutions to trade government bonds at a profit. For instance, 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 be beneficial to society.

  • Many people see central banks as powerful undemocratic technocratic institutions. Central banks have become more independent from the governments since the 1970s. Before that, governments used them to finance their spending via money printing, leading to high inflation. The widely adopted solution was making central banks independent and responsible for containing inflation.
  • Others believe that central banks impede the correct functioning of financial markets by mispricing risk. Without central banks financial markets would be free, and there would be less lending and borrowing because financial institutions have to be more careful. If markets operate freely, bank failures occur more regularly, and banks have to pay more interest to attract deposits to compensate for that risk.

  • The apparent need for central banks is partly the consequence of interest charges. 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 out of thin air by a central bank.

    The apparent need for central banks is also partly the result of liquidity issues because currency yields zero, as is explained in the blog post Permanent Liquidity. Central bank currency is a safe-haven. Its can be attractive compared to other riskier assets in times of crisis. If the interest rate on currency is -12%, currency is less intresting to hold, and financial markets may remain liquid at all times.

    With Natural Money, the holding fee can take over much of the liquidity-providing role of the central bank. And the maximum interest rate of zero can take over much of the inflation-containing task. If inflation rises, lending money at zero interest becomes less attractive, so there might be less credit, and inflation may come down. This arrangement can offer financial stability and make central banks largely superfluous. The blog post Financial Stability Hypothesis explains this in further detail.