Policy Rate

It is the price of overnight reserves between banks. The central bank that sets it is choosing a price, not a quantity, and that one choice propagates outward through every other rate in the economy.

A price in the overnight market

The policy rate is the interest rate at which banks lend reserves to one another overnight, and it is the rate the central bank targets. Reserves are the settlement balances banks hold at the central bank, the most liquid asset in the system. Because every bank must settle its payments, the market for overnight reserves is the one place the central bank can always transact.

A price, not a quantity

When a central bank sets its rate, it announces a target and then defends it by lending or borrowing reserves at rates around that target. It is not choosing how many reserves exist; it is choosing the price at which it will supply whatever quantity the market demands. That is the difference between a price instrument and a quantity instrument.

The choice propagates outward. The overnight rate anchors the cost of short funding, banks price loans, mortgages and deposits off it with a spread, and the whole yield curve is built, maturity by maturity, from the expected path of that rate plus a term premium. Move the anchor and the structure above it shifts.

Using it

Because it is a price, the policy rate can be restrictive or accommodative without any change in the quantity of reserves. A rate held above the neutral level restrains borrowing, and a rate below it encourages it. The signal is in the level relative to inflation and growth, not in the size of the central bank's balance sheet.

One checkable use: when you read that a central bank injected liquidity, ask whether it changed its policy rate. Buying assets changes composition and can support a price, while the policy rate is the deliberate signal. Two different actions on two different margins.

Related: Bank Reserves · Yield Curve · Term Premium

Next: Yield Curve