Definition of policy rate
What is a policy rate?
A policy rate is a short-term reference rate set by a central bank. In reality, there are three different policy rates.
The main one, and the one that everyone talks about in the press, is the refinancing rate. It is the rate at which commercial banks can borrow money from their central bank.
The other 2 key rates are less in the spotlight but are just as important. There is the deposit rate of return, which is the rate of return on banks' reserves with the central bank. Finally, there is the discount rate (term used in the United States) or the marginal lending rate (term used in Europe) which is the rate at which banks can refinance themselves with the central bank, but only if they provide guarantees (assets).
Policy rates: a monetary policy tool
Policy rates are a powerful tool to control the inflation level and economic activity within a country or geographical area. They are one of the main components of monetary policy, led by the central bank.
An increase in policy rates is a means of slowing down an increase in the money supply and therefore of fighting inflation. Effectively, the increase increases the cost of credit but indirectly slows down investment in the country. A rate increase takes place to avoid overheating economic activity.
A reduction in policy rates is a way of boosting a country's economic activity. A decline often occurs as a result of an economic slowdown or a major economic crisis. Lower interest rates provide commercial banks with more liquidity and lower credit costs, which in theory boost investment and therefore economic growth. However, a reduction in policy rates has an inflationary effect.
Impact of policy rates on the stock market
Policy rates are an economic indicator closely monitored by the entire trading world. A change in interest rates has a big impact on the stock markets with very varied effects. But the thing that has the most impact on the stock market is rumour! Rumour of a rise or fall in interest rates has an immediate and powerful effect on all assets. If the rumour is true, the announcement is already included in the asset price. On the other hand, the opposite of what was expected can have a big impact on the stock market.
If a rise or fall in policy rates occurs when stagnation was expected, this causes sudden movements on the stock markets. This is also the case if the increase or decrease is greater than expected.