Beginner2 min read

What moves interest rates

A single number that changes the price of everything else — and why.

Who sets it and why

The central bank sets a base rate at which it lends to commercial banks. Everything else — mortgages, business loans, bonds — is priced on top of that base.

When inflation is high, the bank raises the rate. Loans get more expensive, people spend less, demand falls, and the pressure on prices eases.

When the economy slows and unemployment rises, it works the other way around. That is the whole mechanism: a single price that slows down or speeds up the entire system.

Why shares suffer when rates rise

There are two channels. The first is simple: companies with debt pay more interest, so their profits shrink.

The second is more powerful. A share is worth its future profits brought back to today at a discount rate. Raise the rate and the same future is worth less today — without anything changing at the company.

There is also a third channel, competition: when safe bonds pay 5%, shares have to promise a lot more to attract the same money.

Why the lag is long

A rate change does not work instantly. Existing mortgages refix one by one, business contracts expire at different times, and investment decisions take months.

Economists talk about "long and variable" lags — it usually takes six to eighteen months for the full effect to be felt.

That is why central banks are forced to act on forecasts, not on data. And that is why they regularly get it wrong in both directions.

Key terms in this lesson

Policy rate: The interest rate set by the central bank, on top of which everything else is priced.
Basis point: One hundredth of a percentage point. 25 basis points = 0.25%.
Monetary policy: The central bank's decisions about interest rates and the amount of money in circulation.

Quick check

The central bank raises rates today. When is the full effect felt in the economy?

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