Central banks and interest rates
The answer
A central bank is the institution that issues a country's currency and sets the price of short-term money. It publishes one benchmark interest rate. Almost every other rate in the country — your home loan, your car loan, your deposit, the government's borrowing cost — is built on top of that one number.
Why this costs you money
Most people with a floating-rate home loan cannot answer 3 questions about it.
Which benchmark is it linked to? When does it reset? What is the spread over the benchmark?
Those 3 answers decide how much you pay. Consider a ₹50 lakh home loan with 18 years left. A change of 0.50 percentage points in the rate changes the total interest you pay by several lakh rupees over the life of the loan.
Here is the specific loss. When the benchmark falls, most banks reduce your loan rate only at your next reset date, which may be 3 months away. When the benchmark rises, the same delay applies, but the bank has usually already cut your savings account rate. And when your loan rate rises, many banks quietly extend the tenure instead of raising the monthly payment, so nothing appears to change and you pay for 4 more years.
None of that is hidden. It is written in your loan agreement. Almost nobody reads the reset clause, so almost nobody notices.
How it works
A central bank has 5 jobs. Only the third is in the news.
1. It issues the currency. It is the only institution allowed to create the country's base money.
2. It is the government's banker, and in India it manages the government's borrowing.
3. It sets the policy interest rate, the rate at which commercial banks can borrow from, or lend to, the central bank overnight against government securities.
4. It is the lender of last resort. A solvent bank can be destroyed by a sudden demand for cash. The central bank lends against good collateral so that a liquidity problem does not become a failure.
5. It supervises banks. In India this is a central bank job. In the United States it is shared.
How one rate reaches your loan
The policy rate is an overnight rate between banks and the central bank. It travels outward in a chain.
Policy rate → overnight interbank rate → bank funding cost → deposit rates and lending rates → how much people borrow → how much they spend → prices
The chain also runs into markets. A change in the policy rate changes the yield on government bonds, and the government bond yield is the rate every other future cash flow is discounted at. That is why a rate decision moves share prices that have nothing to do with borrowing.
The corridor
No central bank sets a single rate. It sets a corridor.
In India the repo rate is the middle. The Standing Deposit Facility (SDF) rate is the floor, at which banks can park surplus money with the RBI. The Marginal Standing Facility (MSF) rate is the ceiling, at which they can borrow in an emergency. The overnight market rate lives between the floor and the ceiling.
In the United States the federal funds target range is the announced band. Interest on reserve balances (IORB) pulls the market rate toward the middle and the overnight reverse repurchase (ON RRP) rate sets a floor.
The names differ. The idea is identical: a floor, a ceiling, and a market rate in between that the central bank pushes around.
Independence, and what it is for
An elected government has a short-term reason to want low interest rates, because cheap money makes the economy feel good before an election and the inflation arrives afterwards. A central bank with a mandate that outlives any one government does not have that incentive.
Independence is operational, not absolute. In India the government sets the target and the RBI chooses how to hit it. In the United States the Fed sets its own numerical goal, under a mandate written by Congress. Both can be changed by law. Neither can be overruled on a single decision.
What it tells you, and what it does not
The policy rate is an overnight rate. It controls very short-term borrowing directly. It influences 10-year and 30-year rates only through what people expect the policy rate to average over that period. This is why long-term mortgage rates in the United States sometimes rise on the day the Fed cuts.
A central bank cannot fix a supply problem. It cannot produce oil or unblock a port. When inflation comes from a supply shock, raising rates reduces demand until it matches the reduced supply. That works, and it works by making the country poorer for a while.
Transmission is slow. A rate change takes roughly 4 to 8 quarters to show its full effect on inflation. A central bank is always acting on a forecast, which is why its decisions can look wrong at the moment they are made.
The decision rule
When the benchmark rate changes, do not ask what it means for the economy. Ask 3 questions about your own balance sheet.
1. Is anything I owe linked to this benchmark? If yes, by how much and when does it reset?
2. Is anything I own paying a rate that will now change? Savings account rates move down quickly and up slowly.
3. Am I about to fix a rate? A borrower fixing at the top of a rate cycle and a saver fixing at the bottom are making the same mistake in opposite directions.
Try this now
Five minutes. You will finish knowing exactly how a central bank decision reaches your own money.
- Open your loan account online, or find your loan agreement. Look for the words benchmark, external benchmark, repo-linked, MCLR, SOFR, prime rate or fixed. Write down which one it is.
- Find your spread or margin. Your loan rate equals the benchmark plus this number. If your rate is 8.75% and the repo rate is 5.25%, your spread is 3.50 percentage points.
- Find the reset frequency — monthly, quarterly, or annual — and the date of your next reset. It is a clause in the agreement, usually near the interest rate section.
- Now open your savings account and note the interest rate it pays.
- Subtract. The gap between what your bank charges you and what it pays you is the spread the bank keeps on you.
What you should see. Three things you probably did not know. Your spread over the benchmark is fixed for the life of the loan in most external-benchmark products, so the only thing that changes is the benchmark. Your reset date, not the announcement date, is when a rate cut reaches you. And the gap between your loan rate and your savings rate is usually 5 to 7 percentage points, which is the clearest picture of the banking business you will get in one subtraction.
If your loan is fixed-rate, you have learned something equally useful: the central bank's decisions do not reach it at all, in either direction.
Three real cases
1. Paul Volcker at the Federal Reserve, 1979 to 1982 — independence, and what it costs Volcker became Fed chairman in August 1979 with US inflation running above 11%. The Fed pushed short-term interest rates toward 20%. The result was the deepest recession since the 1930s: unemployment reached almost 11% at the end of 1982, the highest of the post-war era. By October 1982 inflation had fallen to about 5%. Volcker was attacked by farmers, builders and members of Congress throughout. The episode is the standard example of what independence is for — not being right, but being able to continue a painful policy long enough for it to work.
2. India's move to external benchmark lending, 1 October 2019 — the reader's own loan Before this date, Indian floating-rate loans were priced off internal benchmarks the bank itself calculated, most recently the MCLR. RBI rate cuts reached borrowers slowly and partially, because the bank controlled the benchmark. The RBI then mandated that new floating-rate loans to retail borrowers and small businesses be linked to an external benchmark, usually the repo rate, with resets at least once every 3 months. This is why "which benchmark is my loan on?" has a different answer for a 2017 loan and a 2021 loan.
3. Silicon Valley Bank and the Bank Term Funding Program, 12 March 2023 — lender of last resort Silicon Valley Bank failed after depositors withdrew money faster than it could sell assets to meet them. Its bond holdings had fallen in market value because interest rates had risen, so selling them turned a paper loss into a real one. Two days later the Federal Reserve announced the Bank Term Funding Program, lending to banks against government securities valued at par rather than at market price. The design is the lesson: a central bank supplies cash against good collateral so that a rush for cash does not force healthy institutions to sell into a falling market.
The question that resolves it
A novice hears a rate decision and asks: is this good or bad for the market?
An expert asks: what does this change about the rate at which future money is discounted, and who has to refinance in the next 12 months?
The second question has an answer you can check. The first one does not.
What would make this wrong
If the policy rate did not travel into bank rates, none of this would matter. Sometimes it does not travel. In India before 2019 the pass-through of RBI cuts into lending rates was slow enough that the RBI changed the rules to force it. In Japan for many years policy rates were at or below zero and further cuts had almost no effect on borrowing.
Two limits. A policy rate is nearly powerless when the problem is that nobody wants to borrow at any price; cutting from 1% to 0% does very little. And the size of the effect on your own life depends entirely on your balance sheet. A person with no debt and no deposits is barely touched by a rate decision. Most commentary treats a rate change as an event that happens to everybody equally. It does not.
In India
The Reserve Bank of India began operations on 1 April 1935 and was nationalised in 1949. It does more jobs than most central banks.
The policy rate is the repo rate, set by the 6-member Monetary Policy Committee. As of the most recent decision the repo rate is 5.25%. The SDF sits 0.25 percentage points below and the MSF 0.25 above, forming the corridor.
Two quantity tools also exist. The Cash Reserve Ratio (CRR) is the share of deposits a bank must hold with the RBI, and the Statutory Liquidity Ratio (SLR) is the share it must hold in specified securities. Changing the CRR adds or removes money from the banking system directly, without touching the interest rate.
The RBI also manages the government's borrowing programme, manages the exchange rate, regulates and supervises banks and non-bank lenders, and runs the payment systems. That combination is unusual and the last section explains why it matters.
In the United States
The Federal Reserve System was created by the Federal Reserve Act of 1913. It is a Board of Governors in Washington plus 12 regional Reserve Banks.
The policy rate is the federal funds target range, set by the Federal Open Market Committee. The range is currently 3.50% to 3.75%. The Fed steers the market rate inside that range mainly by paying interest on reserve balances rather than by adjusting the quantity of reserves. Reserve requirements were reduced to zero in March 2020 and the Fed no longer uses them as a tool.
The Fed does not manage the exchange rate — that is the Treasury's responsibility, with the Fed acting as its agent. It does not manage the government's debt issuance — that is the Treasury. And it shares bank supervision with the Office of the Comptroller of the Currency and the FDIC.
Where they differ, and what that tells you
The RBI sets monetary policy, regulates banks, manages the government's debt, manages the exchange rate, runs the payment system and issues currency. The Fed sets monetary policy, shares bank supervision, and issues currency. Debt management and exchange rate policy sit with the US Treasury.
That difference produces 2 consequences you can act on.
The RBI faces conflicts the Fed does not. A central bank that also sells the government's bonds has an interest in keeping bond yields low, which is not always what fighting inflation requires. A central bank that also manages the currency may buy dollars to stop the rupee rising, which puts rupees into the banking system and works against a tight policy. When you read an RBI decision, read the liquidity measures alongside the rate. They can pull in opposite directions and often do.
The target is set differently. The Indian government sets the RBI's inflation target by notification, so an Indian policy debate can legitimately be about whether the target itself is right, and that debate happens in public every 5 years when the notification is renewed. In the United States that debate has no scheduled moment and almost never happens.
The practical version is short. In India, watch the liquidity operations, not only the repo rate. In the United States, watch the balance sheet and the language about the future path, not only the target range.
Carry this
- One benchmark rate sits underneath every rate you pay or receive.
- Know 3 things about your own loan: the benchmark, the spread, the reset date.
- The policy rate is overnight. Long rates move on expectations, not on announcements.