Lesson 1 of 25 · 6 min

What a policy rate is, and the one market it directly sets

Exactly one price is set by decision, and everything downstream of it is a consequence that arrives smaller than its cause.

A policy rate sounds like the rate of interest in an economy. It is not. It is a target for the price of money in one specific market, for one specific term, between one specific set of counterparties, and that is the only price a policymaker sets directly.

The market in question is the overnight lending of reserves between institutions that hold accounts with the monetary authority. The term is one day and the participants number in the hundreds. Everything else — a mortgage rate, a term index, the rate on your facility — is produced by other people pricing other instruments in response.

The distinction has teeth because the sizes do not match. Take an illustrative decision of a quarter of a point. The overnight market moves 0.23, because participants trade at slightly different places inside a band. A one-month term index built out of that market moves 0.21 over the following weeks, because it also contains expectations about what comes next. Your rate moves 0.21 at the next reset, because the spread did not move.

So a quarter-point decision arrived as 0.21 of a point: a pass-through of 84 percent, computed as 0.21 divided by 0.25. On a drawn balance of $1,392,000, Act/360, that is $251.72 over a 31-day month and $2,923.20 annualised. Nothing was withheld and nobody decided anything about you. The number crossed three markets and lost a little at each crossing.

The policy rate is the only rate in this track that anyone decides. Every other number in it is a consequence, and consequences arrive at different sizes from their causes.

Key terms

Policy rate: The target a monetary authority sets for the overnight cost of reserves. It governs one market directly and everything else only by consequence.
Overnight market: Institutions lending reserves to each other for a single day. The narrow market a policy rate actually reaches.
Pass-through: The fraction of a policy move that survives into another rate. Rarely the whole of it, and it varies by rate.

Worked example

One decision, three rates

An illustrative quarter-point decision, followed to a statement. All figures invented.

Policy target change: +0.25 points
Overnight market, next day: +0.23 points
One-month term index, over the following weeks: +0.21 points
Your rate at the next reset: +0.21 points
Extra interest, 31 days on $1,392,000, Act/360: $251.72
Annualised: $2,923.20

Four basis points of the decision never reached the statement. That gap is not a discount and not an error; it is what a number loses crossing markets that price different things.

Check yourself

A policy rate rises 0.50 of a point and the one-month index your facility uses rises 0.38. What is the pass-through, and what does the move cost over a 30-day month on a $2,060,000 balance, Act/360?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.