When central banks make decisions, they affect all of us—from mortgage costs to interest rates on savings accounts and portfolio performance. So, how do they decide? This article provides an overview of the process.
Central banks manage the supply of money to help control inflation while strengthening the economy. They also provide key services such as regulating credit, managing currency circulation and keeping track of monetary policy.
Most central banks are independent from political influence. Their independence is a key reason why economic theory suggests that central banks will achieve good macroeconomic outcomes, including low and stable inflation. If monetary policies were under direct political control, politicians might loosen them in the run-up to elections to bolster their chances of reelection, but this would likely lead to unsustainable increases in money growth and ultimately inflation.
The main tool of most central banks is a short-term interest rate that they set for their respective economies. This is called their “policy rate.” Changes in the policy rate affect all other relevant interest rates. When a central bank announces a decision on its policy rate, it will usually also explain why they have done so and how this may affect the economy.
Central banks often work with advisors, managers of their departments and staff in the economics departments to come to a decision on their policy rate. This process happens in a meeting called the risk and recommendations meeting that takes place about a week before the announcement date. This is where all the advice and ideas are shared, allowing the Governing Council to weigh up the risks and benefits of raising, maintaining or lowering the policy rate.
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