What Interest Rates Actually Do

When a central bank changes its policy rate, the headline treats it as a single event with a single consequence. What actually happens is slower, wider, and more interesting.

A rate is the price of time#

An interest rate sets what it costs to have money now instead of later. Raise it and the future becomes cheaper relative to the present: saving is rewarded, borrowing is punished, and any decision that depends on money arriving years from now becomes less attractive today.

That last point is why rates matter so much to asset prices. A business whose profits arrive mostly in the near term barely reprices. A business whose value depends on profits a decade away reprices sharply, because those distant profits are being discounted more heavily.

The transmission is slow#

Policy rates move immediately. Everything downstream does not:

• Floating-rate loans reprice within weeks
• Fixed borrowings reprice only when they mature and are refinanced
• Company investment decisions respond over quarters
• Hiring, wages and consumer spending respond over quarters to years

This lag is why the effect of a rate decision is still arriving long after the news has moved on, and why the economy that a central bank is responding to is always somewhat in the past.

What to read instead of the headline#

The level of the rate matters less than the direction, the pace, and what it implies about the central bank's view of inflation. A single decision is one observation. The path is the information.

Markets do not price the rate. They price the expected path of the rate, and then repeatedly discover they were wrong about it.