Foundations · F8 · 10 min

Central banks and the policy rate

Explain how a central bank sets interest rates, read the market’s odds of a move, and match each of its tools to a problem.

In the news: Rate decision days at the Bank of England, the Fed and the ECB, when interest rates across markets reset.

The essentials

Mandate: The Bank of England’s main job is low, steady inflation, against a 2% target set by the government. The Fed has a : 2% inflation and maximum employment.
The policy rate: The interest rate a central bank sets: in the UK, paid on the money banks hold at the Bank of England. Other rates follow it, and a higher rate makes borrowing dearer, cooling spending and then inflation.
The MPC: Bank Rate is set by the nine-member , which meets eight times a year and publishes each member’s vote. A close split, such as 5–4, signals the next move is near.
Hawkish and dovish: leans towards higher rates, or keeping them high; leans towards cuts. A hawkish surprise usually lifts short-term interest rates and the currency.
Reading market pricing: Rate futures are quoted as 100 minus the rate, so a future at 96.25 implies 3.75%. With 10bp of a 25bp cut priced for a meeting, the market puts the chance of a cut at about 40%.
QE, QT and guidance: creates money to buy bonds, pushing longer-term rates down; runs those holdings down. moves markets by saying what the bank is likely to do next.

Reading the market’s odds

chance of a move ≈ (priced rate − current rate) ÷ size of the move

priced rate: the rate markets expect after the meeting (100 − futures price)
current rate: today’s overnight rate
size: the step being priced: +0.25% for a hike, −0.25% for a cut

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How it works

1. The central bank’s job

A central bank, such as the Bank of England, has one main job: keep inflation low and steady. The UK government sets its target at 2%. The US Federal Reserve also aims for as many people in work as possible: a .

2. One interest rate steers the rest

Its main tool is one interest rate, the , called in the UK. The Bank pays it on money banks keep there, so they won’t lend to each other for much less. Mortgage and savings rates follow it. Higher rates make borrowing dearer and saving more rewarding, so spending, and then inflation, cool.

3. Real rates: tight or loose

What matters is the rate after inflation. Bank Rate of 4% with inflation at 3% is a real rate of about 1%, which holds spending back. With inflation at 6%, the same 4% is a real rate of −2%, which still encourages spending.

4. Who decides

In the UK, Bank Rate is set by the nine-member , which meets eight times a year and publishes how each member voted. A 5–4 vote tells you the next move is close.

5. Hawks and doves

Comments that lean towards higher rates, or keeping them high, are . Comments that lean towards cuts are . A hawkish surprise usually lifts short-term interest rates and the currency; a dovish one lowers them.

6. Futures show the market’s guess

Traders bet on future rates with futures quoted as 100 minus the rate. futures, which track the UK overnight rate, at 96.25 mean the market expects that rate to average 3.75% over the contract’s three months.

7. From pricing to odds

Moves usually come in steps of 25 (0.25%). If the overnight rate is 4.00% and pricing for after the next meeting is 3.90%, the market has priced 10 of a possible 25 basis points: a 40% chance of a cut. Traders read this from futures and from swaps tied to the overnight rate.

8. When rates hit the floor: QE and QT

With rates near zero, a central bank can still push down longer-term borrowing costs by creating money to buy bonds: , or QE. Running those bond holdings down later, by not replacing bonds that mature or by selling them, is , or QT.

9. Lending and talking

In a panic, when healthy banks can’t borrow, the central bank lends to them against good assets through a lending facility. It can also move markets without acting, by saying what it is likely to do next: .

Try it

The 2-year yield is the return on a 2-year government bond, and it tracks where markets expect the policy rate to go. Pull it down as if cuts were priced, or push it up for hikes. Illustrative curve.

Bull steepener2s10s +65bp (from 40bp)

2-year move-30bp10-year move-5bp

Dashed: before. Accent: after. Bull = yields fall (prices rise); bear = yields rise. Illustrative curve.

Worked example

Bank Rate is 4.00% and the overnight rate 3.97%. Market pricing implies the overnight rate will average 3.79% after the next MPC meeting. Inflation is 3.2%. (Illustrative figures.)

Priced change: 3.79% − 3.97% = −0.18%, or −18 basis points.
Chance of a 25bp cut ≈ 18 ÷ 25 = 72%.
If the MPC cuts, only 28% of the move was unpriced, so rates fall only a little.
If it holds, 72% of a cut comes out of prices: short-term rates jump and sterling rises.
Real Bank Rate ≈ 4.00% − 3.2% = 0.8%.

The market prices about a 72% chance of a cut, so a hold would be the bigger surprise.

Check yourself

9 quick questions on the explanation above.

Practice

New numbers every set. Misses and guesses go into your review deck.

In the interview

Answer out loud in under a minute, then compare.

What does the market expect from the Bank of England over the next year, and do you agree?
How does QT affect bond yields?
Two central banks move in opposite directions. What happens to their currency pair?

Remember

P(move) ≈ priced change ÷ size of move

Markets move on the gap between what a central bank does and what was priced, so know the pricing before the decision.

Next · F9Fiscal policy, debt and bond supply

Sources

Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.