Understanding the Process of Central Bank Interest Rate Adjustments

The decision by central banks to adjust interest rates is a critical function aimed at managing economic health, primarily through curbing inflation. When central banks increase interest rates, the immediate effect is that the cost of borrowing rises. This adjustment is designed to reduce spending and investment, thereby dampening inflationary pressures. However, the increase in interest rates also impacts various financial entities and stakeholders in significant ways.

Impact on Borrowers and Lenders

When central banks increase interest rates, borrowers have to pay more for loans, while lenders receive higher returns. This increase in rates directly impacts the balance sheets of both entities. For borrowers, higher interest rates can make new loans less attractive, potentially leading to a reduction in new borrowing. Conversely, it makes existing loans less attractive to repay, which could delay debt repayment but also reduce the volume of new loans issued.

Reduction in Money Supply and Economic Dynamics

Interest rate hikes can lead to a reduction in the overall money supply in the economy. When it becomes more expensive to borrow, people and businesses are less inclined to take on new debt. This can result in a reduction in the money supply as people and companies instead focus on repaying existing debt rather than seeking new financing for expansion or investment. For example, the Fed's rate hikes in 2022 are estimated to have shrunk the money supply by about $500 billion.

Where Does the Money Go?

One common misconception is that when the central bank raises interest rates, money simply disappears. However, it is more accurate to say that money is redistributed among various stakeholders in the financial ecosystem. The reduction in the money supply results in both a decrease in assets and liabilities. People and companies have less money in their pockets or in their bank accounts, and simultaneously, they owe less money as they focus on paying down debt.

Money Redistributes, Not Disappears

Money is not a tangible object with a fixed location. It is, as it were, a conversation between parties with economic interests. When it becomes more difficult to "reach" credit, the conversation simply shifts elsewhere. Just as words don't disappear when the mode of communication changes, money doesn't disappear when interest rates rise; it merely moves to other forms of investment or spending.

The Role of the Federal Reserve

In the United States, the interest accrued from commercial bank loans transfers to the Federal Reserve. The Federal Reserve, in turn, remits all its profits to the U.S. Treasury. This process ensures that the government gains from the broader economic activities facilitated through monetary policy adjustments.

Distribution to Intermediaries

High interest rates may have various implications for financial intermediaries such as banks. Banks operate on a spread, which is the difference between the rate they charge on loans and the rate they pay on deposits. In periods where loan and deposit rates move in tandem, the net profit the bank makes remains largely unchanged. This profit typically flows in the following order:

To depositors: The rate banks pay on deposits (cost of funds). To cover operational costs: All other expenses such as employee wages, salaries, benefits, taxes, utilities, regulatory costs, etc. To shareholders: Any remaining profit after covering operational costs and deposit payments.

It's important to note that while the money is not spent in the traditional sense, it is redistributed through these channels, often back into the economy, albeit in a slightly different form.

Conclusion

The relationship between central banks, interest rates, and financial resources distribution is complex and multifaceted. When central banks adjust interest rates, the financial ecosystem undergoes a series of redistributions that impact borrowers, lenders, and various financial intermediaries. Understanding these dynamics is crucial for both policy makers and parties navigating the ever-evolving economic landscape.