Policy rate
The rate a central bank sets to steer the cost of credit across the economy.
Central banks’ main lever
The policy rate is the rate at which the central bank pays banks on their deposits or lends to them overnight. By moving it, it moves every rate in the economy: interbank, business loans, mortgages, savings accounts. In the euro area the reference is the ECB deposit facility rate; in the US, the federal funds target range set by the Fed.
Hiking or cutting: the two regimes
To curb inflation that runs too hot, the central bank raises its rate: credit gets dearer, demand slows and prices cool with a 12 to 24-month lag. To support a stalling economy it cuts: borrowing gets cheaper and investment and spending pick up. The “neutral” level, neither restrictive nor accommodative, is thought to sit around 2 to 3% nominal for the euro area and a little higher for the US.
What markets watch
Markets anticipate: what matters on a meeting day is the gap between the decision and what was expected, along with the tone of the statement and press conference. Rate futures show at all times the path the market expects from the central bank.
A mortgage when the policy rate rises 2 points
- A €200,000 loan over 20 years at 1.5%: monthly payment of about €965.
- Lending rates follow and reach 3.5%: monthly payment of about €1,160.
- Over 20 years, total interest rises from about €31,600 to €78,400.
Two points of rates more than double the cost of credit: that is how monetary policy slows demand.
the fastest tightening in 40 years
From March 2022 to July 2023 the Fed lifted its range from 0-0.25% to 5.25-5.50%: eleven hikes, four of them of 75 basis points. The ECB went from -0.5% to 4% between July 2022 and September 2023. Both began cutting in 2024 once inflation had come back towards 2 to 3%.
Common mistakes
- Believing a rate cut always lifts stocks: if it answers a recession, profits fall too.
- Forgetting the lags: a hike shows its effect one to two years later.
- Watching only the decision: the guidance on what comes next often matters more.
Questions and answers
Why negative rates?
From 2014 to 2022 the ECB charged banks on their deposits to push them to lend and fight the risk of deflation.
Who decides at the ECB?
The Governing Council: the six Executive Board members and the governors of the euro area national central banks.
Notitia newsroom · education, not investment advice.