Central banks’ 3 policy rates

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Policy rates are one of the main tools of central banks’ monetary policy. They have a big impact on financial markets and the economy. There are also major movements in Forex and global stock markets every time a central bank (ECB, BoJ, BoE, FED, etc.) decides to change them. It should be noted that central banks don’t have one but have several policy rates. The one they impart is the main one, but the other policy rates also have an important economic role.

The main policy rate: the refinancing rate

Definition of refinancing rate

The refinancing rate, also known as the repo rate, is the rate that everyone knows, the one that the media constantly talks about. The refinancing rate is the rate at which banks can borrow from their central bank. It is also the rate used by banks to set their lending rates (with their margin) to individuals and companies.

Open Market Operations

The central bank decides each week on the loan amount it will grant to banks in its country or geographical area, known as open market operations.

The refinancing rate is the base rate, no liquidity is provided to banks below this rate. An open market operation is a bit like an auction, the highest bidder wins. Each bank therefore makes a rate proposal for a certain amount, and the banks that have made the best offers are helped by the central bank.

All banks obviously want to get these funds at a very low cost, which they can then use to lend to their customers (bank loan) or invest on the financial markets (banks are normally not allowed to deal on their own account but they do so anyway).
The amount of funds allocated to banks varies each week and depends on the monetary policy stance chosen by the central bank.

Economic impact of the refinancing rate

A low refinancing rate encourages growth in the number of loans granted by banks and so generates more than money creation. Indeed, low rates make investment more attractive for companies and individuals. In theory, a low rate is therefore supposed to generate inflation.

On the contrary, a high refinancing rate tightens credit flow and so slows down money creation. Investing with a bank loan is more expensive for individuals and companies. In theory, a high rate is supposed to be an effective weapon in the fight against inflation.

The policy rate for remunerating deposits

Definition of the rate of return on deposits

The deposit rate of interest is the rate at which banks' deposits are remunerated with the central bank. It should be noted that all banks are required to have an account with the central bank to deposit their minimum reserves. These minimum reserves are imposed by Basel III regulations. All banks must deposit 8% (plus 2.5% security) of the deposits they receive from their customers, as well as cash obtained from the central bank.

Economic impact of the deposit rate of return

None! It is a gift to the banks. Only the FED’s monetary policy does not remunerate these banks’ deposits.

On the contrary, the mandatory reserve rate has a significant impact on the issuance of credit and therefore on money creation. An increase in the mandatory reserve rate slows down money creation and reduces the number of credits granted and vice versa for a decrease in the reserve rate.

The policy rate for marginal lending

Definition of the marginal lending rate or discount rate

The marginal lending rate, or discount rate, is the rate paid by banks for a loan from the central bank when there are economic difficulties. These are short-term loans used to overcome the lack of liquidity in commercial banks.

In return for this loan, banks must provide collateral for receivables (commercial paper, certificates of deposit, etc.). The interest on the loan is deducted directly from the initial payment.

This marginal discount or lending rate is only used if banks have an urgent need for financing (as is the case in times of economic and financial crisis). Central banks only grant this type of loan for a certain period of time.

The FED and BoJ use the discount rate term while the ECB uses the marginal lending rate term.

Economic impact of the marginal lending rate or discount rate

This rate is mainly used in times of crisis, when there is a crisis of confidence between banks, as was the case during the subprime crisis. The central bank then plays its role as lender of last resort. This prevents a collapse of the banking system.

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