Module 10 · Lesson 5 of 12 · Fundamentals and macro · About 5 minutes
Central Banks and Interest Rates: How Policy Reaches Markets
On this page
Before you read: Economic Events and Headlines: Volatility, Not Instructions
What you will learn
- What a central bank does and what the federal funds rate is.
- How FOMC meetings, statements and projections are published.
- How policy rates connect to bond yields, the dollar and stock valuations, and what quantitative easing and tightening are.
What does a central bank do?
Who decides the interest rate that banks charge each other overnight?
A central bank manages a country’s or region’s money and banking system. Most have a mandate set by law. The US Federal Reserve has a dual mandate of maximum employment and stable prices, and it has said it aims for 2% inflation over the longer run, measured by the PCE price index. The European Central Bank, the Bank of England, the Bank of Japan and the Bank of Canada have their own mandates and tools.
The main tool is a short-term policy rate. In the United States, the Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, the rate banks charge each other for overnight loans, and the Fed steers the rate into that range mainly through the interest rate it pays on reserves banks hold at the Fed. The Fed’s Board of Governors sets that rate.
How are decisions published?
If a decision is announced at 2:00 p.m., what else comes out with it?
The FOMC holds eight scheduled meetings a year, listed in advance on the Federal Reserve’s website. After each meeting, the Fed publishes:
- a statement with the decision and a short assessment of the economy, usually at 2:00 p.m. Eastern Time;
- a press conference by the Chair shortly afterward;
- minutes about three weeks later;
- at four meetings a year, a Summary of Economic Projections, including the “dot plot” of each participant’s view of the appropriate rate path.
Markets react to the decision and to changes in wording, projections and the Chair’s answers. Central bankers’ speeches between meetings can also move prices.
How do policy rates reach other markets?
If the overnight rate goes up, why might a ten-year bond yield move too?
Changes in the policy rate, and in expectations of future changes, spread through markets:
- Short-term yields follow expected policy closely. Futures on short-term rates, such as SOFR futures, show what markets are pricing.
- Longer-term yields reflect expected short rates over many years plus a term premium, so they can move differently from the policy rate. The yield curve lesson covers this.
- The currency often strengthens when a central bank is expected to keep rates higher than others, other things equal.
- Stock valuations are affected because future cash flows are worth less today when rates are higher, and because borrowing costs change.
These are tendencies, not rules. Markets often move before a decision because it was expected, and a decision that matches expectations can produce little reaction.
Policy transmission diagram
Illustrative diagram constructed for teaching. Not real market data.
The diagram shows a fictional chain from a policy rate decision to short-term yields, longer-term yields, the currency and stock valuations, with an expectations box feeding into every step. It is constructed for teaching and is not real market data.
What are QE and QT?
What can a central bank do when its policy rate is already near zero?
Quantitative easing (QE) is a central bank buying large amounts of government bonds and other securities, which adds reserves to the banking system and is meant to lower longer-term yields. Quantitative tightening (QT) is the reverse: letting those holdings shrink, usually by not reinvesting bonds as they mature. Both work alongside the policy rate and are announced with it.
What this does not tell you about central banks
- What any central bank will decide at any meeting.
- How any market will react. The same decision can move prices in different directions at different times.
- Exact schedules and procedures, which central banks publish and occasionally change.
- Nothing here suggests positioning for a decision.
Method in Practice: a decision-day plan
Fictional example. John, Harbor Index futures, the prices, times, costs and results are all invented for teaching. This shows how a written plan can be built and tested. It is not a recommendation, and nothing here says how often this idea works.
Try it on a real chart. Test this idea yourself on past sessions with bar replay. Keep your own count, including the days with no trade.
The idea. A rate decision can move markets twice: at the announcement, and again during the press conference (this lesson). John's futures plan is flat 10 minutes before the 13:00 decision and makes no new trades until 14:00.
John's plan
- Before 13:00
- flat by 12:50
- After 14:00
- The Volume Profile Explained: POC, Value Area, HVN, LVN lesson's entry structure, with today's levels, until 14:30
- Risk
- $150 maximum, costs included
Three outcomes
-
Worked after 14:00: bought at 101.20, sold at 101.60 and 102.00 → +$110
-
Second spike: bought at 101.30. The press conference ran long and the market reversed → −$100
-
No trade: the setup came at 13:20, inside the stand-aside window → $0
Show the full replays
| Replay | What happened | Result after costs |
|---|---|---|
| A | Flat at 12:50. 14:05 entry at 101.20. Limits at 101.60 and 102.00 | +$40 + $80 − $10 = +$110 |
| B | Today's line at 101.20. 14:10 entry at 101.30. At 14:20 a press-conference comment drops price. 30-minute close below 101.20, out at 100.85 | 2 × −0.45 = −$90 − $10 = −$100 |
| C | A clean setup at 13:20 | Inside the window: $0 |
Test it yourself
- Mark every decision date and press conference time in your sample.
- Compare the plan's results on decision days with ordinary days.
- Count the setups the stand-aside window removed.
Where it breaks
- Statements and press conferences can move markets more than the decision itself.
- Liquidity can be thin right after the announcement.
- An unscheduled statement can come any time.
Reflection question: Does your plan cover both the announcement and the press conference on decision days?
Check yourself
- What does the FOMC set a target range for? Hint: the overnight rate between banks.
- Name three things the Fed publishes around a meeting. Hint: statement, press conference, minutes.
- Why can a rate rise produce little market reaction? Hint: what had markets already expected?
Reflect on your own process
- Where does your written plan say to check the FOMC calendar, and what does it tell you to do on decision days?
- When you read a policy statement, how do you record what changed from the previous one in your journal?
- Which primary source would you open first to confirm a headline about a rate decision?
- Does your plan cover both the announcement and the press conference on decision days?