How does a central bank raise interest rates?


I am trying to better understand the concept of interest rates rising and its impact on the FED or BOE, ECB etc (i.e. the lender/creditor) themselves rather than everyone else which is often mentioned. The definition of an interest rate is as follows: An interest rate is the rate at which interest is paid by borrowers (debtors) for the use of money that they borrow from lenders (creditors). I feel I understand the principles behind why they raise and lower rates to stave off inflation, etc. I'm just trying to understand this part a bit more about where the money from increased (or decreased) interest goes (e.g the cycle from the other way around)?


The implementation of monetary policy – e.g., how exactly a central bank raises interest rates – differs across countries and even over time within countries. These differences imply there is not a single answer to your question, but for concreteness, let’s consider the case of the Federal Reserve.

Prior to the recent financial crisis, the Fed primarily implemented monetary policy by setting a target for the federal funds rate, which is an interest rate paid when banks borrow overnight from other banks. The Fed used “open market operations” to pursue that target; that is, by selling (purchasing) securities, the Fed reduced (increased) the supply of bank reserves, thus leading to a higher (lower) federal funds rate. However, in the aftermath of the financial crisis and the Fed’s large-scale asset-purchase programs, the banking system has a large amount of excess reserves, meaning that the traditional approach to raising interest rates will no longer work. Rather the Fed intends to affect the federal funds rate by changing the interest paid on excess reserves or by conducting overnight reverse repurchase agreements. Both policies entail the Fed paying interest to financial institutions in order to pull the federal funds rate and other short-term market interest rates into the target range via arbitrage. (Please see the recent article by Ihrig, Meade and Weinbach in the Journal of Economic Perspectives for a comprehensive, yet easily accessible, overview of how the Fed will implement monetary policy when the FOMC decides it’s time to raise interest rates.)

Where will these interest payments come from? To answer this question, we must understand the Fed’s balance sheet, the income it derives from its balance sheet, and what it does with that income. The Fed holds assets – primarily Treasury and Mortgage-Backed securities – that it purchased by issuing reserves. The Fed’s net income earned – i.e., the interest from the assets less the interest paid on reserves and operational expenses – is remitted to the U.S. Treasury. In fact, the Fed has remitted around $475 billion to the Treasury over the past 6 years. As the Fed raises short-term interest rates, its interest payments on reserves will increase and its remittances to the Treasury will decrease. (Carpenter et al. (2015, IJCB) provides further details and projections of what the Fed’s balance sheet and remittances may look like going forward.)

Last updated on
May 18, 2023

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