How does the policy rate work?

The policy rate issue is often misunderstood by the public. However, we know that the key rate is equivalent to the monopoly of the price on the economic and financial system. The evolution of the rate often explains the variation of most assets, including the most volatile ones, such as cryptocurrencies. Explanations and analyzes of the key rate mechanism.

The ECB key rate

The (sole) mandate of the ECB is that of price stability, by keeping inflation close to 2%. Also, it is important to note that the central banking system is barely a century old. Indeed, central banks are fairly recent institutions in economic history (Free Banking and cryptocurrencies – Tremplin.io). The existence of central banks converges with an increasingly centralized banking market.

The interbank system and the different rates

In the banking system, the ECB is the “bank of banks”. It sets the key rate, which, as its name suggests, determines the credit conditions for the entire market (banks, businesses, households, etc.). The ECB does not have just one key rate, but three. The objective of the ECB is to act on the interbank market. The interbank market is a market reserved for banks that finance themselves in the short term by exchanging funds or securities. This market is particularly decisive, since it determines the minimum rate at which banks can borrow or lend. We then distinguish three key rates of the ECB:

• First, theand ceiling rate (or marginal lending facility). This rate is used by banks to finance themselves in the event of an urgent need for liquidity for 24 hours from the ECB. In August 2022, this rate is 4.5%.
• Afterwards, ECB refinancing rate. This refinancing rate allows the ECB to inject liquidity on a weekly basis. This was the main policy rate in 2008.
• Finally, the floor rate or deposit facility rate. In the presence of a liquidity surplus, the banks can place the funds remunerated at this rate with the ECB. In August 2022, this floor rate is 3.75%. This is the rate we usually discuss.

Consequently, banks never have an interest in borrowing above the ceiling rate (because the ECB is systematically providing funds at this rate). In the same way, banks never have an interest in lending below the deposit facility rate, because the ECB will always offer a minimum rate of return. It follows that the interbank market rate is between the floor rate and the ceiling rate.

The interbank rate

The interbank rate provides the pulse of financial and monetary activity. Thus the 24-hour market rate corresponds to the EONIA rate, while the EURIBOR interbank rate relates to duration ranging from one week to 6 months. This rate is between 3.7% and 4%. The chart below shows the one-week EURIBOR rate and the three-month EURIBOR rate. We observe the good correspondence between the floor rate of the ECB and the interbank rate practiced.

Taylor’s rule

Taylor’s monetary rule is an economic model proposed by American economist John B. Taylor in the 1990s. Thus, this rule aims to determine the optimal interest rate set by a central bank according to the evolution of the economy and the inflation target. The idea behind the Taylor rule is to provide a transparent and predictable framework for monetary policy, while allowing the central bank to respond appropriately to economic changes. The Taylor rule formula is described as follows.

Target interest rate = neutral nominal interest rate + 0.5 * (inflation gap) + 0.5 * (output gap)

Therefore, the target interest rate is the rate that the central bank should set to achieve its inflation and growth objectives. The neutral nominal interest rate is the interest rate that corresponds to the neutral level of the economy, i.e. when inflation is stable and the economy is at its full potential without inflationary pressures or deflationists. We also talk about potential growth.

It is also important to note that the ECB, unlike the FED, only has inflation in its mandate. It should therefore (theoretically) not take into account the sensitivity of growth.

Determining deviations from production and inflation

Also, the inflation gap is the difference between actual inflation and the central bank’s inflation target. If inflation is above the target, the inflation gap will be positive. And if it is lower than the target, the deviation will be negative. The Taylor rule proposes a proportional response to the inflation deviation, which means that if inflation is above the target, the central bank should raise the interest rate to dampen economic activity and reduce inflation. ‘inflation. If inflation is below target, the central bank should cut the interest rate to stimulate economic activity and encourage higher prices.

Similarly, the output gap is the difference between the economy’s actual level of output and its maximum potential. When the economy is operating above potential, the output gap is positive, indicating economic overheating, while if it is operating below potential, the output gap is negative, indicating underutilization economic resources. Finally, the coefficients (here 0.5) are determined by economists according to priorities and economic possibilities.

The impact of the interbank rate on the markets

There is a saying that interbank market crises are the “mothers of all crises”. Indeed, if the short rates on the interbank market are high, this may mean that banks have difficulty obtaining liquidity. This can reflect high market risk, which often affects the economy through instability in the banking system.

Furthermore, we note a non-negligible correlation between the key rate and the financial markets (close to +40% here). It may seem counter-intuitive, but an increase in the key rate can reflect the existence of robust economic growth or high inflation, often indicating high results. On the contrary, the fall in the interest rate may reflect a deterioration in economic conditions (job market, etc.). Even if the drop in the long-term interest rate is a bullish factor for the markets, the cyclical drop in the key rate often heralds corrections or crashes.

It is also notable, in the case of cryptocurrencies, that the last bull market was manifested from the end of the period of falling rates. Conversely, the peaks of 2018 and 2022 were synchronized with an early or mid-term hike in the key rate. We mention here the case of bitcoin for its good correlation with the evolution of stock market indices.

An impact of the key rate on the whole economy

The key rate, as we have shown, directs access to credit for the entire banking system. Under these conditions, it is clear that the borrowing possibilities for businesses, households and governments are determined by the key rate. Banks have no interest in lending to households or companies below the floor rate proposed by the ECB. The ECB thus intends to play on the number of loans granted. This reduces or increases the amount of money in circulation. In the United States, the historic rise in interest rates is causing the money supply to decline, while in the euro zone, the latter continues to increase slightly.

Nevertheless, we will notice that there is a good symmetry between the inflation rate and the key rate. In economic history, almost all of the time, the policy rate is higher than inflation. But since 2000, agents have become accustomed to a negative real rate, ie the key rate was below inflation. It was only a few months ago that this trend was reversed, perhaps permanently for the United States…

The question also arises as to whether it is inflation that determines the rates or the reverse…

In conclusion

Ultimately, we showed how the interest rate was set by the central bank. The interest rate monopoly is held in the euro zone by the ECB, which, through these three key rates, determines the credit conditions of the interbank market. We will thus mention the role of the floor rate (minimum return on capital), the ceiling rate (loan at the minimum rate), and the average refinancing rate. Commercial banks therefore trade with each other under the conditions set by the ECB. This then has repercussions on all credits, and therefore mechanically, on the economy and the financial markets. Thus stock markets are well correlated to long to medium-term rates, and the evolution of the latter can often herald corrections or crashes.