When the Federal Reserve announces a rate change, headlines proclaim that borrowing costs will rise or fall. But the Fed doesn't actually set your mortgage rate or the interest on your savings account. It adjusts a single obscure rate—the one banks charge each other for overnight loans—and somehow this ripples through the entire financial system.

The journey from a policy announcement to the rate on your car loan involves a sophisticated machinery that most people never see. Central banks don't command rates to change; they engineer conditions that make certain rates nearly inevitable. Understanding this machinery reveals why some policy changes work instantly while others take months to bite.

This transmission process determines whether monetary policy actually reaches the real economy or gets stuck in the financial plumbing. When transmission breaks down—as it did during the 2008 crisis—central banks find themselves pushing on a string. The mechanics matter because they explain both the power and the limitations of the most important economic policy tool we have.

Every bank maintains an account at the central bank, holding reserves that serve as the ultimate settlement currency for interbank payments. When Bank A's customer sends money to Bank B's customer, reserves flow between these accounts. Banks need enough reserves to settle transactions and meet regulatory requirements, but holding excess reserves costs money—those funds earn less than they could elsewhere.

Central banks exploit this by adjusting the total supply of reserves in the banking system. When the Fed buys government securities from banks or dealers, it pays by crediting reserves to the seller's bank. More reserves in the system means banks compete less aggressively to borrow them from each other, pushing the overnight rate down. Selling securities reverses this: reserves drain from the system, scarcity increases, and overnight rates rise.

The beauty of this mechanism lies in its precision. The Fed doesn't need to transact with every bank—it trades with a handful of primary dealers, and the effects propagate instantly through arbitrage. If one bank has excess reserves while another needs them, the market rate adjusts until supply meets demand. The Fed simply controls how much total supply exists.

Before 2008, the Fed conducted these operations daily to hit its target rate within a few basis points. The market was so finely tuned that traders could predict operations based on morning reserve estimates. This scarce reserves framework meant small open market operations produced large rate effects—a testament to how well the plumbing was understood by all participants.

Takeaway

Central banks don't set interest rates by decree—they manufacture scarcity or abundance in the reserves market, and competition among banks does the rest. The overnight rate emerges from supply and demand just like any other price.

Open market operations work elegantly when reserve levels are modest, but they become unwieldy when central banks flood the system with liquidity—as happened during quantitative easing. With trillions in excess reserves, daily fine-tuning becomes impossible. Central banks needed a different approach: instead of controlling quantity, they would bound the price.

The corridor system creates two standing facilities that any bank can access. The deposit facility lets banks park excess reserves overnight at a guaranteed rate—this becomes the floor. No bank would lend to another bank at a lower rate when it can deposit risk-free at the central bank. The lending facility provides reserves on demand at a penalty rate—this becomes the ceiling. No bank would borrow from another at a higher rate when the central bank offers unlimited funds.

Between these bounds, the market rate floats based on conditions, but it cannot escape the corridor. The Fed's current system pays interest on reserve balances (IORB) as its floor and offers the discount window as its ceiling. The European Central Bank operates similarly with its deposit facility and marginal lending facility. The width of the corridor reflects how much rate volatility the central bank tolerates.

This framework proved essential when balance sheets exploded after 2008. With $3 trillion in reserves, traditional open market operations couldn't possibly drain enough to create scarcity. Instead, the Fed simply raised the floor rate, and market rates followed. The floor system meant policy could tighten even with abundant reserves—a crucial adaptation that made exit from crisis policies possible.

Takeaway

When reserves are abundant, central banks control rates through the price they pay on deposits rather than the quantity of reserves. The floor rate becomes the policy rate because no rational bank lends below what the central bank guarantees.

The overnight rate is just the first domino. From there, policy must transmit through a chain of interconnected markets before reaching the rates that matter for spending and investment. This pass-through varies dramatically by market, by country, and by economic conditions—explaining why rate changes sometimes pack an immediate punch and sometimes seem to disappear.

Short-term wholesale rates respond almost instantly. Three-month Treasury bills, commercial paper, and interbank lending rates track the policy rate tightly because arbitrage opportunities are immediate and transaction costs minimal. Banks can switch between reserves and short-term securities freely, so these rates stay anchored to policy expectations. Bond markets move on announcements, often before the actual rate change takes effect.

Retail rates are stickier. Banks adjust deposit rates slowly, partly due to menu costs and partly because depositors don't switch accounts over small rate differences. Loan rates depend on competition, risk assessment, and existing contract structures. Fixed-rate mortgages respond to long-term bond yields, which incorporate expectations about future policy, not just current rates. A rate hike today might not affect mortgage rates much if markets expect cuts later.

The most variable pass-through occurs in credit spreads. During financial stress, the gap between policy rates and actual borrowing costs can widen dramatically as lenders demand higher compensation for risk. In 2008, the Fed slashed rates aggressively, but corporate borrowing costs barely budged because credit spreads exploded. Transmission broke down precisely when it was needed most—teaching central banks that rate policy alone cannot always reach the real economy.

Takeaway

Policy rate changes hit wholesale markets within hours but may take months to fully reach mortgage rates and business loans. Watch credit spreads—when they widen, it signals that policy transmission is weakening and rate cuts may not translate into easier borrowing conditions.

Central bank rate control is neither magic nor mandate—it's plumbing. By adjusting reserve supply through open market operations and bounding rates through standing facilities, monetary authorities engineer the conditions that make their target rate the market equilibrium. The system is elegant precisely because it works through market forces rather than against them.

Understanding transmission mechanics reveals both the power and fragility of monetary policy. When plumbing works smoothly, a quarter-point move in the policy rate cascades predictably through the financial system. When it doesn't—when credit spreads blow out or banks hoard liquidity—the same policy change produces nothing.

The next time you hear about a rate decision, look beyond the headline number. Ask whether transmission channels are functioning, whether credit spreads are stable, and whether the change will actually reach borrowers. That's where policy effectiveness truly lives.