How Central Banks Actually Set Interest Rates Today

How central banks steer short-term interest rates using corridors and floors, why paying interest on reserves became central, and how India's system works.

Central banks announce a policy interest rate, but how do they make market interest rates actually follow it? The answer has changed in recent decades.

The corridor system

In a corridor system, the central bank sets:

A ceiling: the rate at which banks can borrow from the central bank.
A floor: the rate the central bank pays on deposits.

Market interest rates between banks stay within this corridor. By managing the amount of reserves, the central bank keeps market rates close to its target inside the corridor.

The floor system

After 2008, central banks created enormous amounts of reserves through quantitative easing. With reserves abundant, banks no longer needed to borrow from each other much, and market rates would have fallen toward zero. To control rates, central banks began paying interest on reserves. Banks will not lend money more cheaply than the rate they can earn safely at the central bank, so this rate acts as a floor. The U.S. Federal Reserve began paying interest on reserves in 2008 and now operates what is often described as an “ample reserves” or floor system.

India’s system

The Reserve Bank of India uses a corridor:

Repo rate: the main policy rate at which the RBI lends to banks against government securities.
Standing Deposit Facility rate: introduced in 2022 as the floor, where banks can park surplus funds without collateral.
Marginal Standing Facility rate: the ceiling, for emergency borrowing.

The RBI aims to keep the weighted average call rate, the overnight interbank rate, close to the repo rate by managing liquidity.

Why the floor holds

If the central bank pays banks 5 percent on reserves, a bank would not lend to another bank overnight at 3 percent, since it can earn 5 percent risk-free by leaving money at the central bank. So market rates stay at or above around 5 percent. Paying interest on reserves gives the central bank control over rates even when reserves are plentiful.

Thinking central banks set all interest rates directly

Central banks directly control only short-term rates like their policy rate. Loan, deposit and bond rates are set by banks and markets, influenced by the policy rate, expectations and risk.

Key takeaways

Central banks steer short-term rates using corridors or floors.
A corridor has a borrowing ceiling and a deposit floor.
With abundant reserves, paying interest on reserves sets a floor for rates.
The RBI uses the repo rate, the Standing Deposit Facility floor and the Marginal Standing Facility ceiling.