Money, interest rates and the central bank
An interest rate is the price of money, and like any price it is a ratio between how much there is and how much is wanted.
Lesson 7 of 12. It is the longest chain of cause and effect in this branch, and everything after it depends on it.
What money is, in the two forms that matter
Money began as a medium of exchange — a way to get what you needed without finding somebody who wanted exactly what you had. Before it, trade meant bartering goods against goods, which works only when two people want each other's surplus at the same moment.
What we use now is fiat money, which needs no physical commodity behind it. Its value comes from supply and demand and from public willingness to use it — nothing else. That is not a weakness, but it has one consequence worth holding on to: if value depends on supply and on confidence, then anything that changes either of those changes the currency. Almost everything in the rest of this lesson is a mechanism for changing one of them.
How much money there is, measured in rings
"How much money exists" has no single answer, because money shades from cash into things that are nearly cash. So it is measured in nested aggregates, each adding something less liquid than the last.
- M0 — base money, or high-powered money: notes and coin, plus the reserves private banks hold at the central bank. This is the layer a central bank controls directly.
- M1 — active money: notes and currency in circulation, current account balances and travellers cheques. Money that can be spent today without converting anything.
- M2 — M1 plus savings balances and smaller time deposits: money that is one short step from being spendable.
- M3 and wider — large deposits and institutional funds: still money in an economic sense, but not in any sense a shopper would recognise.
How the supply is changed
The central bank — the Federal Reserve in the United States — is the institution that can change how much money exists. Broadly, expanding supply makes money cheaper and more plentiful, and contracting it does the reverse. The mechanisms are lesson nine's subject; what matters here is the direction of effect.
More money, other things equal, means a lower price for it — a lower interest rate — and a currency that is less scarce and therefore worth less against others. Less money means a higher rate and a stronger currency. That single sentence is behind most of the currency reactions in this branch.
The interest rate is the price of money
Once that framing is in place the source's questions answer themselves, and it is worth doing them in order.
Is there only one interest rate? No. There is a rate at which banks lend to each other overnight — in the United States the federal funds rate — a rate at which the central bank lends to banks, the rates banks charge their own customers, and a yield on every government bond at every maturity. The policy rate is the anchor; everything else is priced off it with a spread for time and for risk.
If the rate rises, what happens to commodities? They tend to fall, for two reasons that stack. Holding a physical commodity earns nothing and costs storage, so a higher rate makes the alternative — cash earning interest — more attractive. And a higher rate usually strengthens the dollar, which lowers the dollar price of everything quoted in it, exactly as lesson six showed for oil.
And to currencies — which rises and which falls? The currency whose rate rose strengthens, because capital moves toward the higher return. But it is always relative: what matters is the differential between the two currencies in the pair, not the level of either.
- A rate rise strengthens the currency that raised it — relative to a currency that did not.
- A rate rise weighs on commodities twice: through the cost of holding them and through the currency they are priced in.
- The policy rate is one of many rates. When a lesson here says "the rate", it means the policy rate unless it says otherwise.
Rates, inflation and growth
Two more of the source's questions, and they are the two that make the rest of the calendar legible.
Rates and inflation. Raising the rate is the standard response to inflation. Expensive money means less borrowing, less spending, weaker demand and therefore less upward pressure on prices. It is deliberately blunt, and it works with a lag long enough that the central bank is always acting on a forecast rather than on what it can see.
Rates and growth. The same mechanism run backwards. Cheap money encourages borrowing and investment, which supports growth — and if it is left cheap too long, produces the inflation the rate then has to rise to fight. This is why the two questions are really one, and why a central bank's job is usually described as a balance rather than as a target.
So a rate cut is aimed at stimulating a slowing economy or averting a contraction, at the cost of a weaker currency. A rate rise is aimed at cooling demand and inflation, at the cost of slower growth — and with a stronger currency as a side effect that the trader cares about more than the central bank does.
Two ways a rate comes about
This is the distinction the whole branch is organised around. A rate is arrived at in two quite different ways at once.
It is set — decided by a committee at a scheduled meeting, published to the minute, and unchanged until the next one. That is the event of lesson nine.
It is discovered — continuously, by the bond market, in the yields investors accept to lend to a government for two years or ten. Nobody decides those. They are the price at which lending happens, and they move every second the market is open. That is lesson eight.
The order matters more than it looks. The discovered rate usually moves first, because the bond market is pricing what it expects the committee to do before the committee does it. By the time the decision is announced, most of it is already in the price — which is why a rate rise that surprises nobody can be followed by the currency falling.
Reading a statement, a dot plot and a set of market odds
Three documents surround every meeting, and each answers a different question.
The statement is the decision plus a short explanation. Its wording is worked over for weeks, so it is read by comparison rather than on its own — what changed since last time, which qualifier was dropped, whether "transitory" survived. A statement identical to the previous one is itself a message.
The dot plot shows where each member of the committee expects the rate to be at the end of each of the next few years, one dot per member, unattributed. It is not a promise and it is not a vote. What it gives you is the spread of opinion and the median, and what moves markets is the median moving between meetings — the source's own exercise asks the reader to set a direction on EUR/USD, AUD/USD, gold and the Dow from exactly that.
The market-implied odds — CME Group publishes them from federal funds futures — are what traders are actually paying for, expressed as a probability of each outcome at each future meeting. This is the number to check before any rate event, because it is the definition of what is already priced in.
- Read the statement against the last one, not on its own.
- Read the dot plot for the median and for how it moved, not for individual dots.
- Read the implied odds before deciding a decision is a surprise. A 95% priced hike that arrives is not news.
What to take from this one
Three things:
- A currency is worth what it is because of how much of it exists and how much it pays. Rates and money supply are the two levers on that, and they are the same lever seen from two ends.
- A rate rise strengthens its currency, weighs on commodities, cools inflation and slows growth. Every one of those is relative and every one arrives with a lag.
- The rate is discovered by the bond market before it is set by the committee. That is why the curve comes next, and why a decision everyone expected can move nothing.
Next: the bond market gets there first
Bond prices and yields move opposite ways, the curve between two maturities says what the market expects, and the ten-year has led the dollar at every meeting.