Part II: How does the central bank change the interest rate?

In part I, we explained how central banks used interest rates to influence the strength of their respective currencies. But how do they do this? Changing interest rates is not quite as simple as fiddling with a dial to achieve the desired outcome, it requires a little more finesse than that. The exact mechanisms differ slightly from country to country, and are often tediously technical, so we’ll stick to basic principles whenever possible.

Let us first return to supply and demand. We mentioned previously that a lower interest rate is tied to a weaker currency and a higher money supply. If we exploit this correlation, then by changing the money supply we can manipulate the interest rate. As per the chart below, by moving the supply to the left or right of the demand curve, we decrease or increase rates.

Traditionally, modifying the money supply has been a major tool in a central bank’s arsenal for controlling interest rates. It does so via the buying and selling of government bonds. The exact nature of a bond falls outside of the scope of this article, but in the simplest terms, it is an IOU from the government. When the central bank buys a government bond, it takes that bond and pays cash into the system, increasing the available supply of money. Conversely, by selling that bond, it takes that cash back, reducing the available supply. The buying and selling of bonds therefore has a direct impact on the money supply.

The central bank has another tool at its disposal: it can tell regular banks how much money they must hold in reserve. This means that every bank has to hold a certain percentage of its deposits with the central bank. This limits the amount of money the bank has to lend out to its customers. Imagine a reserve rate of 10%. The bank has customer deposits worth one thousand Dollars. This means the bank is required to keep $100 with the central bank, while having $900 to use however it wishes, typically lending it out. Increasing or decreasing the reserve requirement therefore reduces or increases the amount of money in the system.

Finally, a central bank dictates the rate at which regular banks can borrow money from it. Although during normal operations banks usually borrow from each other, the central bank can act as a lender of last resort, setting a form of baseline interest rate for inter-bank lending. This in turn affects the rate at which those banks can profitably lend money to their clients, and to each other, once again indirectly affecting the money supply.

The above is important to understand from a historical perspective, but unfortunately, it explains economic conditions that have long since departed us. The tools previously described work in an environment of restricted monetary liquidity, or more concretely, they work when banks are forced to borrow money to cover their normal operations. This is no longer the case.

The financial crisis of 2008 changed everything. Following the crash, governments the world over enacted measures to inject liquidity into their economies in order to stimulate growth. Interest rates went straight to zero and central banks began injecting vast amounts of cash into their banking systems and mass purchasing assets - a process known as quantitative easing - hugely increasing the money supply. Supply and demand have flown out of the window because the fact of the matter is that the supply is now so large that manipulating it is utterly futile. Mathematically one may as well operate under the assumption that it is in fact infinite.

A new monetary era requires new monetary tools. How to influence banks when they don’t need to worry about limited reserves? The answer is to incentivise them. For the United States’ Federal Reserve, this is called interest on reserves. For the European Central Bank, it is called the deposit facility rate. The Bank of England simply calls it the bank rate, which previously meant something else. Different names but the purpose is the same: the central bank pays regular banks to deposit their cash reserves with them. For clarity, we will use the term “interest on reserves” from here on.

By earning interest on deposits held at the central bank, regular banks now have an extra option for their excess cash reserves. The bank can now lend money out to borrowers, earning interest payments from customers, or it can deposit that money at the central bank, earning interest on reserves. This creates a type of money marketplace where the various interest rates charged and offered by the bank never deviate too far from the rate fixed by the interest on reserves. The effective interest rate of a given currency therefore ties in closely with the interest on reserves awarded by the central bank.

One might expect the effective interest rate to be higher than the interest on reserves. After all, if a bank can earn more money from the central bank than it can by lending it out, then why bother taking the risk? The key here is that only banks can deposit their reserves at the central bank; nonbanks are not eligible for such a system. These nonbank lenders, lacking such an option, have an incentive to lend at any rate above zero, thereby lowering the overall effective interest rate. Banks are all too happy to borrow this money because they can arbitrage the spread between the lower interest repayments and the higher interest on reserves.

The 2008 crash prompted drastic changes in the way our monetary system works. Up until that point, banks operated within a framework of limited liquidity, forcing them to shore up their reserves and borrow enough to remain solvent. Following the crisis, the framework changed to one of extreme abundance, a completely different game. As recent as these changes are, whispers of another system of monetary governance are already emerging. How it will function is anyone’s guess, so let us once again anchor ourselves to the most fundamental definition of an interest rate: it is the price of using money. For as long as we retain any kind of debt-based monetary system, interest rates will remain the cornerstone of our financial world.