The key interest rateThe price of money behind every market.
The key interest rate is the most powerful tool a central bank has. It sets the price of money, and through that it moves borrowing, spending, inflation, stocks, property and the currency.
The price of money
The key interest rate is the rate at which commercial banks can borrow money from the central bank. Every other rate in the economy is built on top of it: the interest on a mortgage, a business loan, a credit card and a savings account. When the central bank moves its key rate, all of them follow.
That makes it a lever for the whole economy. Low rates make borrowing cheap, so people and companies borrow, spend and invest more. More money flows through the economy, growth picks up and, after a while, prices start to rise. High rates do the opposite: borrowing gets expensive, less money flows and inflation cools down.
When central banks raise and when they cut
A central bank has one main job: stable prices, which for most of them means inflation of about 2% a year. Too much inflation eats into savings and wages, and falling prices are just as dangerous, as the lesson on inflation and deflation showed.
So every decision follows the state of the economy. When inflation runs above 2%, unemployment is low, wages are high and consumption is at its peak, the economy is near the top of its cycle and the central bank raises rates. In a recession, or when inflation is too low or negative, it cuts. A currency that has become too strong can also be a reason to cut, because it hurts exports.
No single number decides. Central banks weigh the whole picture, and they usually tell the market which way they lean long before they move. Their words often move the market before the decision does, and the lesson on quantitative easing shows how to read that tone.
What a rate hike does to markets
Stocks love cheap money. When rates fall, companies can finance themselves cheaply and investors expect bigger profits, so share prices are lifted. When rates rise again, that cheap money disappears and stock markets come under pressure, sooner or later.
For a currency trader, the most important effect is on the currency itself. Money flows to where it earns the most. When a central bank raises rates, holding its currency pays more, so demand rises and the currency tends to gain. When rates are cut, demand falls and the currency tends to weaken. The euro is a prime example of this.
Property feels it too. Higher rates make mortgages and instalments more expensive, so fewer people can buy and some are forced to sell. Demand falls while supply rises, and prices come down. Precious metals such as gold also tend to lose value when rates go up.
| Market | Usual reaction | Why |
|---|---|---|
| Money supply | Shrinks | Higher rates mean less lending |
| Stocks | Under pressure | Cheap money disappears |
| Bond yields | Rise | New bonds have to pay more |
| The currency | Tends to gain | Money flows to the higher return |
| Property | Prices fall | Mortgages get more expensive |
| Gold and silver | Tend to fall | They pay no interest |
| Inflation | Declines | Less money chasing goods |
The market moves before the bank does
By the time a central bank announces a decision, traders have usually priced it in. If everyone expects a hike of 0.25%, the hike itself changes little. What moves the currency is the surprise: a bigger or smaller step than expected, or a change in what the bank signals for its next meetings.
That is why traders follow the expectations, not only the decisions. Interest Rate Probability shows what the market expects: if a hike is already 90% priced, the hike alone will barely move the currency, and your trade idea has to be about the surprise. Try it below: the decision stays the same, a cut of 0.25%. Move what the market had priced in beforehand and see how differently the same cut reads.
| Meeting | Hold | Cut 25bp | Cut 50bp | Implied rate |
|---|---|---|---|---|
| Sep | 8% | 30% | 62% | 4.87% |
| Nov | 5% | 41% | 54% | 4.52% |
| Dec | 12% | 58% | 30% | 4.31% |
In short
- The key rate is the price of money. Every loan and savings rate in the economy follows it.
- Central banks raise rates when inflation runs above about 2% and the economy is near its peak. They cut in a recession or when inflation is too low.
- A hike tends to lift the currency and weigh on stocks, property and gold. What moves the market most is the surprise against what was expected.
Questions
How often do central banks decide on rates?
The Fed, the ECB, the Bank of England and the Bank of Japan each hold 8 rate meetings a year. The dates are fixed well in advance and listed in the Economic Calendar.
Key terms
- Key interest rate
- The rate a central bank sets for lending to banks. It drives borrowing costs across the economy and is one of the biggest drivers of a currency.
- Central bank
- The institution that sets a country’s key interest rate and controls the money supply, like the Fed, the ECB or the Bank of England.
- Money supply
- The total amount of money in an economy. More money chasing the same goods tends to push prices up.
- Bond yield
- The return an investor earns on a bond. Yields rise when bond prices fall. Short-term yields follow rate expectations, long-term yields follow inflation and growth.
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.
- Recession
- A period in which the economy shrinks instead of growing, usually with rising unemployment.