Policy rate
Capital MarketsThe interest rate a central bank sets to steer the economy, and the anchor under every other rate in that currency.
Also written: Bank Rate, official interest rate
The policy rate is the rate at which a central bank lends to and takes deposits from the banking system. In the euro area the European Central Bank sets it for every member of the currency union at once; in the UK the Bank of England's Monetary Policy Committee sets Bank Rate for one economy. Both institutions have operational independence over the decision, and neither takes instructions on it.
It transmits outward in layers. Money market rates follow almost immediately, bank lending rates follow as loans reprice or are renewed, government bond yields reflect the expected path of the rate over their life, and every discount rate in every valuation model sits on top of that. This is why a policy decision reaches a DCF that has nothing obvious to do with monetary policy.
The level matters far less than the path. Markets price what they expect the central bank to do, so a decision moves prices only to the extent it differs from what was already assumed. A cut that is smaller than expected can tighten financial conditions, and a hike that was fully priced can leave markets unmoved, which is why the reaction to a decision so often looks backwards to someone reading only the headline.
The policy rate anchors the short end of the curve. Longer yields also carry a term premium, the extra compensation investors want for locking money up, so a long yield is not merely an average of expected policy rates. That gap is one reason the yield curve is a noisier signal than the commentary around it suggests.
Worked example
Illustrative. The policy rate rises 100 basis points. A borrower on a floating rate loan sees its coupon reset 100 basis points higher at the next reset date, and its cash interest bill rises within months.
A borrower on a fixed rate bond feels nothing until it refinances, at which point the whole move arrives at once. Same rate change, two completely different timing profiles.
The ten year yield may move much less, and can even fall, if the market reads the rise as slowing growth enough to require cuts later. The short end tracks policy; the long end tracks expectations about policy plus a term premium.