What a central bank does, and what a policy rate is

What a central bank does

The International Monetary Fund (IMF) describes monetary policy as the way central banks manage economic fluctuations and achieve price stability. Central banks often have other roles as well. Bank Negara Malaysia is one example. It states that its mandate is to promote monetary stability and financial stability conducive to the sustainable growth of the Malaysian economy, and it lists these roles:

• Monetary policy: keeping prices stable while supporting growth.
• Currency and reserves: it is the sole issuer of the national currency and manages the country's international reserves.
• Liquidity and exchange rates: managing them so that monetary policy targets are achieved.
• Payments: promoting reliable, secure and efficient clearing, settlement and payment systems.
• Banker and adviser to the Government.

Some central banks also supervise banks; in other economies a separate agency does. The rest of this course deals with the first role: monetary policy, and how it reaches the people and firms who borrow.

What a policy rate is

A policy rate is a short-term interest rate that a central bank sets to signal the stance of its monetary policy. Bank Negara Malaysia says that its Overnight Policy Rate (OPR) is the sole indicator used to signal that stance. The central bank keeps the average overnight interbank rate, the rate at which banks lend to each other for one night, close to the OPR, and that rate sets guidance for other interest rates in the economy. Bank Negara also notes that it does not directly influence the level of other short-term and long-term interest rates and bond yields.

The IMF explains the chain in the same way: open market operations affect short-term interest rates, which in turn influence longer-term rates and economic activity. When a central bank lowers its policy rate, monetary policy is easing; when it raises the rate, policy is tightening.

Many names, one idea

Central banks give their policy rates different names, and set them on different schedules:

• Malaysia: the Overnight Policy Rate, decided by a Monetary Policy Committee that meets at least six times a year.
• Thailand: the policy rate is the one-day bilateral repurchase rate, decided by the Monetary Policy Committee at six meetings a year. The Bank of Thailand uses its operations to steer short-term money market rates in line with it.
• The Philippines: in 2016, the governor of the Bangko Sentral ng Pilipinas explained that the overnight reverse repurchase rate would remain its key policy rate within a new interest rate corridor.
• The United States: the Federal Open Market Committee sets a target range for the federal funds rate, the rate banks charge each other to borrow overnight, and has eight regularly scheduled meetings a year.
• The euro area: the European Central Bank sets three key rates every six weeks, and the deposit facility rate, which banks receive on overnight deposits with it, is the rate through which it steers its stance.

The names differ, but each is a very short-term rate at which banks deal with the central bank or with each other. Lesson 3 shows how central banks keep market rates close to the rate they set.

Steering through the exchange rate

Not every central bank uses an interest rate. The Monetary Authority of Singapore (MAS) has conducted monetary policy by managing the Singapore dollar exchange rate since 1981, and says it does not control domestic interest rates or money supply growth. MAS explains that Singapore is a small and very open economy, where the exchange rate has a greater influence over domestic inflation than interest rates.

MAS manages a trade-weighted index, the Singapore dollar nominal effective exchange rate (S$NEER), which weights currencies by the importance of each trading partner. It lets the index move within a policy band and sets the band's slope, its midpoint and its width. Economies where much borrowing and saving is in foreign currency face other limits on what a policy rate can do; a later course on monetary frameworks in ASEAN covers them.

A worked example

Rate changes are usually counted in basis points. One basis point is one hundredth of a percentage point, so, for example, a cut from 3.00% to 2.75% is a cut of 25 basis points. What it means for a borrower depends on how much of the change the lender passes on.

Change in annual interest = loan balance × change in the loan rate

• Take an illustrative variable-rate loan with a balance of 1,000,000 in local currency.
• If the lender lowers the loan rate by the full 25 basis points, annual interest falls by 1,000,000 × 0.25% = 2,500.
• If it lowers the loan rate by only 15 basis points, annual interest falls by 1,000,000 × 0.15% = 1,500.
• A fixed-rate loan does not change at all until it is repriced or refinanced.

Lesson 5 explains why the change that reaches borrowers is often smaller and slower than the change in the policy rate.

Where to find the current rates

Policy rates change at scheduled meetings, so their current values should always be checked on a source that is kept up to date. The policy rate page lists the rate or framework of each market in Southeast Asia, with Hong Kong and India for comparison. The next lessons look at why central banks are given their mandates, how they make the rate hold in the market, and how a change travels to the loan rates that households and firms pay.