Why interest rates matter less than they used to

For decades, interest rates held the spotlight in global markets, business decisions and household finances. The Fed, ECB, and Bank of England set rates and investors, consumers, and policymakers would react accordingly. A quarter-point change could drastically alter markets. However, this reliance on interest rates has been challenged. Central banks have discovered that one rate cannot manage the complexities of today's interconnected global economy.

In the 2008 financial crisis, slashing interest rates wasn't enough to restore confidence. Banks were hesitant to lend and investors uneasy about asset purchases. Policymakers had to think differently and introduced new measures like buying government bonds, providing emergency funding to banks, and injecting liquidity into markets. They realized that maintaining financial stability was as crucial as influencing borrowing costs.

This approach continued during the Covid-19 pandemic, with central banks using liquidity management tools to support markets. Many expanded their toolkit further, using facilities to keep money markets flowing smoothly. For households, the mortgage rate announced by central banks is only part of the story. Banks also consider their own funding costs, competition, and liquidity when deciding on mortgage rates for customers.

Business loans are similarly influenced by factors beyond the policy rate. A company looking to expand may find that access to credit depends on banking conditions and liquidity, in addition to central bank policy shifts. Even savers are impacted, as deposit rates increasingly reflect competition for funding and banks' balance-sheet needs, rather than tracking central bank rates directly.

Investors face a more complex financial picture. Stock markets, bond yields, and currencies react to interest rate decisions, but they also respond to changes in central bank balance sheets and liquidity operations. In some cases, these announcements have been as influential as changes in benchmark rates.

Central banks are now using a broader toolkit to manage financial conditions and support specific sectors. This targeted approach allows for more flexibility but also makes policy decisions less predictable and more difficult for businesses and households to understand. While interest rates remain important, they now operate alongside a growing set of complementary tools, such as liquidity management. When central banks keep rates unchanged, financial conditions may still change significantly through these other tools.