Controlling the interest rate

How the interest rate control system works

The Riksbank’s ability to control interest rates in the economy stems from its capacity to set the interest rate when a monetary policy counterparty (mostly banks) needs to deposit or borrow funds at the central bank with one day’s maturity. The interest rate from one day to the next is called the overnight rate. By controlling the overnight rate, the Riksbank influences short-term market rates. In simple terms, short-term market rates should reflect the expected path of the overnight rate. All else equal, a higher rate level leads to lower activity in the economy and hence lower inflationary pressures, and vice versa. 

 

The Riksbank has several instruments at its disposal to control the overnight rate.

 

Firstly, the Riksbank supplies so-called standing facilities. This means that the banks can borrow money from, or deposit money with, the Riksbank overnight. The interest a bank receives when it deposits money with the Riksbank overnight is known as the Riksbank's deposit rate. Correspondingly, the bank pays the Riksbank's lending rate if the bank borrows money from the Riksbank overnight. The deposit rate is the "floor" and the lending rate is the "ceiling" in what is known as the interest rate corridor, which is tied to the repo rate with plus/minus 0.75 percentage points. The overnight interest rate will invariably lie inside the interest rate corridor because a bank with a need to borrow can always borrow from the Riksbank at the lending rate and a bank with a need to invest can always deposit the surplus in the Riksbank at the deposit rate. As there is a difference between the deposit and lending rates, banks have an incentive, when lending from each other, to agree on an interest rate that lies between the rates they would pay to or receive from the Riksbank.

 

Secondly, the Riksbank uses the repo rate as its most important signalling rate. With this rate, the Riksbank signals the level of the overnight rate one week ahead. The Executive Board of the Riksbank makes decisions on the repo rate. A repo, or repurchase agreement, is the purchase of securities with a simultaneous agreement to repurchase them a specified number of days later. If the banking system has a deficit towards the Riksbank, this is met by the Riksbank carrying out a repo transaction every week (i.e. the Riksbank purchases securities). If the banking system instead needs to deposit, the Riksbank issues Riksbank Certificates. At present, the banking system as a whole needs to deposit money in the Riksbank.

 

Thirdly, the Riksbank implements fine-tuning operations every day to stabilise the overnight rate. This is achieved by the banking system as a whole being able to borrow from or deposit at the Riksbank, normally at the repo rate plus/minus 0.1 percentage points, depending on whether there is an overall surplus or deficit towards the Riksbank at the end of the day. As a result, the overnight rate is kept inside a band that is narrower than the interest-rate corridor and contributes to clearer monetary policy signalling.

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