The Central Bank’s Policy Rate

The interest rate that a central bank sets and that it announces publicly is normally the rate at which it is willing to lend money to the commercial banks.

This policy rate can be achieved by using short-term collateralized lending rates, known as repo rates.

Central bank buys bonds (usually government bonds) from the banks, with an agreement to sell them back at some time in the future – repurchase agreement. The central bank earns the repo rate.

Central bank increases official interest rate, commercial banks increase base rates.

A commercial bank’s base rate is the reference rate on which it bases lending rates to all other customers.

The Bank of England’s refinancing rate (official policy rate) is the two-week repo rate.

The federal funds rate (or fed funds rate) is the interbank lending rate on overnight borrowings of reserves.

The Federal Open Market Committee (FOMC) seeks to move this rate to a target level by reducing or adding reserves to the banking system by means of open market operations. The level of the rate is reviewed by the FOMC at its meetings held every six weeks.

Through the setting of a policy rate, a central bank can manipulate the amount of money in the money markets.