Base Rate
The base rate is the interest rate set by a country's central bank that serves as the foundation for other interest rates in the economy. It is the primary instrument of monetary policy in most modern economies, influencing the cost of borrowing and the return on saving throughout the financial system. By changing the base rate, a central bank seeks to influence spending, investment, inflation, and employment.
Definition
The base rate is the interest rate at which the central bank lends to, or borrows from, commercial banks, or the rate at which banks hold reserves with the central bank. Because all other interest rates in the economy are linked, directly or indirectly, to this rate, changes in it are transmitted throughout the financial system.
Different countries use different names for essentially the same concept. The federal funds rate is the rate at which United States depository institutions lend reserves to each other overnight, and its target is set by the Federal Reserve. The refinancing rate is used by the European Central Bank, the Bank Rate by the Bank of England, and the rediscount rate or repo rate in various other jurisdictions.
The transmission mechanism
Changes in the base rate affect the economy through several channels.
The interest rate channel operates through the cost of borrowing. When the base rate falls, banks reduce the rates they charge on loans, encouraging households to borrow for consumption and firms to borrow for investment. Conversely, a rise in the base rate increases borrowing costs and restrains spending.
The credit channel operates through the availability of credit. Lower rates improve the balance sheets of borrowers and lenders, increasing the willingness of banks to extend loans.
The asset price channel operates through the valuation of assets. Lower interest rates raise the present value of future cash flows, boosting the prices of shares, bonds, and property, which increases household wealth and encourages consumption.
The exchange rate channel operates through international capital flows. Lower domestic interest rates reduce the return on domestic assets, weakening the domestic currency, which stimulates exports and raises import prices.
The expectations channel operates through the signals that rate decisions convey about the central bank's intentions and its assessment of the economy. Expectations of future rates influence long-term interest rates and the behaviour of households and firms.
How the base rate is set
Central banks set the base rate through their policy-making committees, which meet at regular intervals to assess economic conditions and determine the appropriate stance of monetary policy. Decisions are based on a wide range of indicators, including inflation, growth, employment, and financial conditions.
Many central banks operate under an inflation target, typically set around two percent per year. When inflation is expected to rise above target, the central bank may raise the base rate to restrain demand; when inflation is below target or the economy is weak, it may lower the rate to stimulate activity.
The setting of the base rate involves difficult trade-offs. Raising rates to control inflation may slow growth and raise unemployment; lowering rates to support growth may fuel inflation or encourage excessive risk-taking. Central banks must weigh these considerations, often in the face of uncertainty about the economy's underlying condition.
The zero lower bound
In severe downturns, central banks may cut the base rate to very low levels, even to zero or slightly below. At this point, known as the zero lower bound, conventional monetary policy becomes constrained, because further cuts would require lenders to accept negative nominal interest rates, which they are generally unwilling to do when cash can be held instead.
When the base rate reaches the zero bound, central banks may employ unconventional measures. Quantitative easing involves large-scale purchases of financial assets to inject liquidity and lower longer-term interest rates. Forward guidance involves communicating intentions about future policy to shape expectations. Some central banks have experimented with negative interest rates.
The base rate in practice
The base rate is one of the most closely watched economic variables, because it influences the cost of mortgages, business loans, savings, and government debt. Changes in the base rate are quickly transmitted to variable-rate loans and to the returns on savings accounts.
The effectiveness of base rate changes depends on the state of the economy and on the responsiveness of households and firms. In deep recessions, even very low rates may fail to stimulate borrowing if confidence is weak and demand for credit is low—a situation described as "pushing on a string."