Setting interest rates

In the usury financial system, central banks manage the money supply via interest rates. When the central bank lowers interest rates, borrowing money becomes cheaper, making it more attractive to go into debt for consumption or investment. As a result, the money supply increases at a faster pace, thereby boosting consumption and investment. When the central bank raises interest rates, the opposite happens, so the money supply increases more slowly, or even decreases.

Central banks boost the money supply because usury promotes a money shortage. Most money is a debt, on which debtors pay interest. Debtors must return more than they borrowed. That money may not be available if those with surpluses don’t spend their balances, requiring additional borrowing to prevent disruptions in money flows. Classical economics questions this idea. If the money flows become interrupted, sellers lower their prices, and those with money will spend more to pick up these bargains.

Transmission via the bond markets

Based on estimates of future short-term central bank interest rates, financial institutions, such as banks, borrow short-term funds from the central bank at its interest rate to buy longer-term government bonds. If banks expect the short-term interest rate to remain below 2% in the coming year and 1-year government bonds yield 3%, they may borrow short-term money from the central bank to buy these bonds, repay them when they mature, and pocket the 1% difference.

The trade creates demand for these bonds, causing their prices to rise and yields to fall. Perhaps traders stop buying the bond when the interest rate drops to 2.5% because there is always a risk that the central bank will raise interest rates during that year. If one-year bonds yield 2.5%, and ten-year bonds yield 4%, another trader might sell one-year bonds and invest the proceeds in ten-year bonds, thereby lowering their yield as well. Usually, this happens in futures markets, so traders often don’t own these bonds.

Traders borrow short-term money to lend it for longer, pocketing the interest rate difference. If traders believe the central bank will raise interest rates, they sell bonds, causing bond prices to fall and yields to rise until yields reflect the expected interest rate hike. Central banks have goals related to inflation, economic growth, and employment. Hence, inflation, GDP, and employment numbers reveal a great deal about what central banks will do. So, if unemployment rises, bond yields might fall.

Setting interest rates

Financial news regularly covers central bank decisions on interest rates. Economists claim that financial markets determine interest rates based on the supply and demand of funds. That seems contradictory. So, who sets the interest rate? The actions of central banks affect interest rates and the availability of funds. The standard explanation is that central banks set short-term interest rates based on their estimates of the economy and inflation. By doing so, they influence long-term interest rates via bond market trading.

Financial markets discipline central banks via trust. Traders may believe that a central bank is doing a poor job. If inflation increases while the government runs growing deficits and the central bank doesn’t raise interest rates sufficiently, the value of its currency could drop, and inflation could spiral out of control. To prevent this, the central bank may raise interest rates to protect the currency and to avoid inflation. Higher interest rates could put government finances at risk, prompting the government to reduce spending.

Altering markets

Central bank critics argue that central banks distort financial markets by eliminating the market mechanism. Central bank interventions have a profound impact on the operation of financial markets. As a result, there is more lending than would have occurred otherwise. Central banks create liquidity in financial markets by providing short-term funds that banks use to buy bonds with different maturities. It allows banks to buy and sell these government bonds, enabling them to match their lending and borrowing needs at any time.

So, how does that work? Apart from lending to customers, banks invest in government bonds, which they can sell at any time in financial markets. If a corporation requests a one-million-euro loan that matures in five years, the bank might sell a government bond that matures in five years as well. In that case, the bank eliminates interest risk, as it knows the interest it would have received by keeping the bond and the interest it will receive from the loan.

In the past, banks had to be careful because they couldn’t borrow easily from the central bank, nor did they invest in or trade government bonds. So, if you applied for a mortgage, the bank looked for matching term deposits. Perhaps you could obtain a 5-year mortgage if sufficient 5-year deposits were available. If, after five years, the bank lacked adequate deposits, you would not be able to renew your mortgage and might have to sell your home. And so, you would think twice before getting a mortgage.

Economists call these markets inefficient. You couldn’t get a 30-year mortgage. The operation of central banks has altered financial markets, making them more efficient. That can be beneficial for the economy. The Industrial Revolution started in England, which had the most efficient financial markets. The central bank needs the trust of financial markets. Financial markets can lose confidence in a central bank, leading to a decline in the currency’s value. A central bank can try to restore trust by raising interest rates.

Subsidising the financial sector

Central banks reduce the risk of bank failures. When borrowers repay their debts, banks are solvent. However, they may still find themselves short of cash in their vaults when depositors withdraw their deposits. Central banks create this money if needed, so banks need less cash in their vaults. Central banks can also rescue troubled banks, thereby reducing the risk to the broader economy. After all, a financial crisis can lead to an economic crisis, such as the Great Depression. That nearly happened in 2008.

There are public benefits to stabilising the financial system, but these benefits exist due to interest on money and debts, thus usury. Usury creates a shortage of funds that requires management. Central banks subsidise the financial sector in the following ways:

• Central banks mitigate the risk of systemic failure, enabling financial institutions to take on more risk and lend more. Banks may make risky loans to profit from higher interest rates, assuming the central bank will bail them out if things go wrong.
• Central banks signal their intentions to financial markets. When the central bank intends to change interest rates, it provides advance notice so financial institutions aren’t caught off guard and can adjust their bond portfolios accordingly.

The supply and demand of funds in the financial markets ultimately determine interest rates. Still, these markets would operate differently without central banks, with significantly less borrowing and lending. Central banks make the financial system function more smoothly and reduce the risk of systemic failure. As a result, interest rates are lower than they would otherwise be.

Central banks are powerful, undemocratic, technocratic institutions. Since the 1970s, they have become independent from governments. Before that time, governments used their central banks to finance their deficits by printing money, leading to inflation and a loss of trust in their currencies. Making the central bank independent from politicians and giving it a mandate to keep inflation low was a move to instil confidence in fiat currencies.

The argument in favour of central bank independence is that a government must be trustworthy to its creditors. Creditors, like most of us, don’t trust politicians because they spend other people’s money. Since then, governments have borrowed in financial markets and paid interest on their debts. Central banks still buy government debt and return the interest to the government, which is the same as printing money outright.

Central banks can impede the functioning of market mechanisms in financial markets by bailing out troubled banks. Without central banks, financial institutions would have to be more careful. However, bank failures would still occur, and probably more often, so banks would pay higher interest rates to depositors to compensate for the risk of lending them money. Higher interest rates negatively impact economic growth.

Signalling intentions

Central banks signal their intentions in advance to prevent traders from being caught off guard, thereby avoiding chaos in financial markets. That issue became at the centre of a drama that played out in the UK bond markets in September 2022. Interest rates spiked after the government announced a massive spending package. It suddenly became clear that the Bank of England might have to raise interest rates much further than previously thought to contain inflation. The spending plan caught financial institutions off guard. The Bank of England had to intervene in the bond market to bring down interest rates.

Financial institutions borrow short-term money from the central bank and invest it in the bond market. To borrow this money, financial institutions pledge these bonds as collateral, just like your house is the collateral for your mortgage. If interest rates rise, the value of these bonds decreases due to the effect of discounting. A UK bond trader noted, ‘If there was no intervention today, yields on UK government bonds could have gone up to 7-8 per cent from 4.5 this morning, and in that situation, around 90 per cent of UK pension funds would have run out of collateral. They would have been wiped out.’

An institution might raise £1,000,000 in equity, borrow £9,000,000 from the Bank of England at an interest rate of 1.75%, and invest £10,000,000 in ten-year bonds at 3% interest, pledging the bonds as collateral for the loan. The institution could earn £142,500 per year on a £1,000,000 investment, yielding a handsome 14.25% return if market conditions remain stable. But it is a dangerous bet due to discounting. The price of a bond is its net present value. If the yield on ten-year bonds were suddenly to rise from 3% to 4%, the institution would incur a loss of £811,090, which is the difference in the bond’s net present value. That would nearly wipe out the entire equity. And that happened that day.

In the past, when interest rates were higher, pension funds invested directly in bonds; however, bond yields have since declined. Pension funds have fixed obligations, such as paying retirees £1,000 per month until they die. If interest rates are low, pension funds would have to raise premiums to reach the agreed-upon amount, an unpopular move. People love freebies, such as getting more than they have paid for. To pump up their revenues, pension funds invested in stocks and speculated in the bond market using leverage. It seemed like easy money because central banks signal their intentions in advance. This time, however, the government took the traders by surprise, so the central bank had to rescue them.

Permanent liquidity

When liquidity is high in financial markets, you can buy or sell financial instruments such as stocks and bonds at any time. In other words, you can sell them in financial markets for currencies such as the euro or the US dollar. During a financial crisis, liquidity becomes scarce, and it becomes harder to sell financial instruments. Their price collapses because there are many sellers and few buyers. Only cash and government bonds perform well in those times. Financial pundits refer to it as a flight into safety. To prevent a crisis, central banks inject liquidity into the financial system. In other words, they lower interest rates, making it attractive for investors to borrow from the central bank.

In this way, the central bank prints new money. It can end the crisis because investors can use this new cash to buy stocks. Since the 1987 stock market crash, central banks have increasingly resorted to injecting liquidity, also known as printing money, to quell financial crises. If currency is plentiful, short-term interest rates drop, and stocks and bonds become more attractive investments, so there will be buyers. Once interest rates are near zero, the central bank can’t lower them. Market participants may accumulate central bank currency rather than invest in stocks because they find a zero interest rate more attractive.

Investors will hold onto their cash. With interest rates near zero, traditional methods for addressing financial crises became ineffective. Central banks adopted extraordinary measures, such as quantitative easing (QE), in the aftermath of the 2008 financial crisis and the 2012 euro crisis. Traders say, ‘Cash is king.’ In times of crisis, when there is blood on the streets, as they say, they want cash to pick up bargains while small and inexperienced investors get slaughtered, so they can be the vultures picking the carcasses and get rich once the market recovers. That is colourful language, and it is stock-market trader talk you might find on message boards. Financial instability results from usury. Debts may not get repaid. Cash is the ultimate means of payment. If your bank goes bankrupt, your deposit might be gone, but you can still pay with banknotes, which are the central bank’s currency. That further destabilises the financial system.

During a financial crisis, investors worry about whether their stocks will retain their value, as the economy may be on the verge of collapse. That is why investors prefer the currency of a central bank. That is only due to the interest rate on cash. When everything else is crashing, zero becomes a very attractive interest rate. If there had been a 12% annual holding fee on central bank currency and cash, investors would seek alternatives to cash and central bank currency, and the market would always maintain liquidity, so that the central bank might not have to take action. In that case, we may not need a central bank’s currency for liquidity purposes. It then becomes a unit of account or administrative currency.

In times of crisis, investors rush to buy safe financial instruments, such as government bonds. With Natural Money, administrative currency is unattractive because of the holding fee. Holding on to the currency will cost you 12% per year, meaning a euro will be worth 88 cents after a year. Interest rates on government debt may go as low as required, such as -5%, to make other investments more attractive and bring liquidity back into the markets. And lo and behold, there will always be liquidity.

No one wants to own currency that costs 12% per year to hold. It will mark the end of the administrative currency’s role as a reserve. Currently, banks are required to keep the central bank’s currency to meet their reserve requirements. That is unnecessary. Equity requirements are more helpful than currency reserve requirements. Government debt can also serve as a suitable reserve. Currently, banknotes are also the central bank’s currency. A 12% holding fee would make cash unattractive to use. Cash should be backed by short-term government debt with a more favourable interest rate.

Latest revision: 13 November 2025

Featured image: Ara Economicus. Beverly Lussier (2004). Wikimedia Commons. Public Domain.