Central banks, policy rates and the economy
A central bank sets one short-term interest rate, and that rate spreads into mortgages, loans, bonds and share prices. This lesson compares the US Federal Reserve and the European Central Bank: what each is asked to do, how their rates moved from 2022 to 2026, and how a change spreads to spending. A calculator then applies the Taylor rule, a famous rule of thumb, and shows how much its answer depends on inputs nobody can observe. It ends with Lennar, a homebuilder, through the years of higher rates.
- Level
- Beginner
- Reading time
- About 28 minutes
- Know this first
- GDP, cycles and jobs
By the end you will be able to:
- describe what the Federal Reserve and the European Central Bank are each asked to do
- explain how a change in one policy rate reaches borrowing, spending and prices
- separate the nominal policy rate from the real policy rate
- apply the 1993 Taylor rule and say why its answer depends on estimates
- see how higher rates can show up in a company's orders, prices and revenue
The price of borrowing
The last three lessons covered prices, inflation, output and jobs. This one covers the institution that is asked to keep those in balance: the central bank. It does not set the price of bread or the number of jobs. It sets one interest rate, a short-term one, and lets that rate spread through the whole system of loans, bonds, mortgages and savings accounts.
That makes it central to finance. Nearly every valuation, loan and budget in this course uses an interest rate somewhere, and the rate they all start from is the one a central bank chooses. The lesson uses two of the largest, the US Federal Reserve and the European Central Bank, because they were asked to do almost the same job and took the same step on the same day. It then shows a rule of thumb for what the rate "should" be, and follows one homebuilder through the years of higher rates.
What each bank is asked to do
The Federal Reserve Act directs the Fed to promote the goals of maximum employment, stable prices and moderate long-term interest rates. Because the first two are the ones that move the policy rate, this is called the dual mandate. The Fed's policy committee, the FOMC, does not set a numerical target for employment, because maximum employment depends largely on factors that interest rates do not control. It does set a number for prices: inflation of 2 percent a year, measured by the personal consumption expenditures (PCE) price index. The PCE index is a different measure of consumer prices from the consumer price index used in the inflation lesson.
The ECB's task is narrower on paper. Its primary objective is to maintain price stability in the euro area, and its strategy statement of 30 June 2025 describes that as aiming for two per cent inflation over the medium term, with a commitment that is symmetric. Symmetric means that inflation below the target is as unwelcome as inflation above it. The same statement says that, without prejudice to price stability, the Eurosystem supports the general economic policies of the European Union.
| US Federal Reserve | European Central Bank | |
|---|---|---|
| Main objectives | Maximum employment, stable prices and moderate long-term interest rates (the dual mandate) | Price stability in the euro area |
| Inflation target | 2% a year, measured by the PCE price index | 2% over the medium term, applied symmetrically |
| Rate tracked here | Federal funds rate, target range 3.75% to 4.00% | Deposit facility rate, 2.50% |
| Last change in this lesson | Raised by 1/4 point, 16 September 2026 | Raised by 0.25 point, 16 September 2026 |
In practice both banks end up watching the same dials. Low and stable inflation is the shared aim, and the Fed adds a look at jobs. When the two goals pull in different directions, such as prices rising while unemployment rises, the Fed has to weigh them, which is one reason the dual mandate is harder to apply than a single target.
The tool: one short-term rate
The Fed's main tool is a target for the federal funds rate, the overnight rate at which banks lend reserve balances to each other. The Fed cannot set that market rate directly. It changes the interest it pays banks on their reserve balances, and since banks are unlikely to lend to each other for less than they can earn from the Fed, the market rate follows the target. The ECB works with a set of three key rates, of which the one tracked below is the deposit facility rate, the rate banks earn on money they leave with the central bank. As of 16 September 2026 it is 2.50%, with the main refinancing rate at 2.65% and the marginal lending rate at 2.90%.
Other tools exist. The Fed describes large-scale purchases of longer-term securities, about $3.7 trillion over six years, begun during the 2007–09 crisis, and forward guidance, which is public communication about the likely path of policy, used when the short-term rate was near zero. It states that changes in the federal funds rate are the primary way policy is changed.
From one rate to the whole economy
The Fed describes the chain in four steps. A change in the federal funds rate moves short-term rates quickly, such as Treasury bill yields and floating-rate loans. Longer-term rates respond to what people expect the policy rate to do next, so words matter as much as actions. Changes in rates also affect share prices, house prices, household wealth, credit terms and the dollar's exchange rate. Together these change spending on durable goods, housing and business investment. Lower rates make borrowing cheaper and tend to raise demand; higher rates do the reverse. If demand runs too weak, unemployment rises and inflation falls, and if it runs too strong the opposite happens.
This is the demand curve of the first lesson shifting for the whole economy at once, with the inflation of the second and the output and jobs of the third as the results. The path of the two banks' rates since 2022 shows how large the moves can be.
| Month | Fed funds rate, monthly average | ECB deposit rate, in force on the last day |
|---|---|---|
| December 2022 | 4.10% | 2.00% |
| July 2023 | 5.12% | 3.50% |
| August 2024 | 5.33% | 3.75% |
| January 2025 | 4.33% | 3.00% |
| December 2025 | 3.72% | 2.00% |
| June 2026 | 3.63% | 2.25% |
| September 2026 | 3.75% | 2.50% |
The ECB raised its deposit rate from 0.00% on 27 July 2022 to 4.00% on 20 September 2023, in nine further increases, a rise of 4.00 percentage points in about fourteen months. It then cut eight times, by 2.00 points in total, to 2.00% in June 2025. The Fed's rate followed a similar shape: the monthly average was 0.08% in January 2022, 5.12% in July 2023 and 5.33% in August 2024, then 3.72% in December 2025. On 16 September 2026 the FOMC voted 12 to 0 to raise the target range by one quarter of a percentage point to 3.75% to 4.00%, noting that inflation remains elevated and that economic activity is expanding at a solid pace. The ECB raised its deposit rate by the same quarter point, to 2.50%, on the same day. The sources do not say why, and the two banks decide separately, so the match shows only that they moved in the same direction on the same day.
A rule of thumb: the Taylor rule
How high should the policy rate be? In 1993 the economist John Taylor proposed a simple rule that has been used as a yardstick ever since. It starts from a neutral level of the real interest rate, the rate after taking away inflation, which Taylor set at 2 percent. It adds the current inflation rate to get the neutral nominal rate. Then it adjusts: raise the rate when inflation is above target, and raise it when output is above its potential level, which is what economists call a positive output gap. Cut it for the reverse. The Atlanta Fed, which publishes a calculator, writes the weight on the output gap as 0.5, the value from the 1993 rule, and reports Taylor's output gap as the percentage-point difference between real GDP and an estimate of its trend.
Notice what the second line does. When inflation rises by one point, the rule asks the policy rate to rise by one and a half points, one to match inflation and half a point more. The rate then rises faster than prices, so the real rate goes up and demand cools. That extra half point is the main idea of the rule: to bring inflation down, real borrowing costs have to rise, not just keep up. The rule also shows how the real policy rate, the nominal rate less inflation, is the true measure of how tight policy is.
The rule has real weaknesses, which the Atlanta Fed itself points out. Neither the neutral real rate nor the output gap can be observed. Both are estimates, and replacing Taylor's 2 percent with a model-based estimate of the neutral rate can change the prescription a great deal; the page notes that one such estimate was just below zero at the time it wrote. The page also says that former Fed chairs Ben Bernanke and Janet Yellen have preferred other versions of the rule, and that its own version counts only gaps that show slack. The calculator below uses the symmetric 1993 form with PCE-style 2% as the target. It is fed the consumer price index, because that is the series used earlier in this module, so it is an illustration and not the way the Fed makes decisions.
Try the rule
Set the three inputs: current inflation, the output gap and the neutral real rate. The calculator works out what the rule prescribes and compares it with the middle of the Fed's target range after the 16 September 2026 decision, which is 3.875%. It starts with inflation at 3.7%, the 12-month change in US consumer prices for September 2026, an output gap of zero, which is an assumption and not a measurement, and Taylor's neutral real rate of 2%.
With inflation at 3.70%, output at potential and a neutral real rate of 2.00%, the 1993 Taylor rule prescribes 6.55%. The Fed’s target midpoint of 3.88% is 2.68 points below the rule, so policy is looser than the rule suggests. After inflation, the real policy rate is 0.18%.
Four experiments. First, leave the starting settings alone. The rule prescribes 6.55%, which is 2.68 points above the Fed's range midpoint, and the real policy rate is only 0.18%. Second, lower inflation to 2.0% and keep the other two settings. The rule falls to 4.00%, within 0.13 points of the midpoint. With inflation at target and output at potential, the rule is simply the neutral real rate plus 2. Third, put inflation back to 3.7%, set the output gap to −2 points and the neutral real rate to 0.5%. The rule is now 4.05%, 0.18 points above the midpoint. The same inflation produced 2.50 points less, only because two inputs that nobody can observe were changed, which is the point to hold on to. Fourth, set inflation to 0%, the gap to −6 points and the neutral rate to 0%. The rule prescribes −4.00%. The Atlanta Fed notes that it does not constrain its prescriptions to be non-negative, so a rule can ask for a rate that is hard to deliver. When the Fed's rate was near zero, with a monthly average of 0.09% in January 2021, it turned to the securities purchases and forward guidance described above.
One company through the higher-rate years: Lennar
A homebuilder is one of the clearest places to see the transmission chain, because many of its customers borrow to buy. Lennar is a US homebuilder with a financial year that ends on 30 November. Its fiscal 2023 followed the Fed's rapid rise in rates, and its results release of 14 December 2023 gives the comparison with fiscal 2022. In the words of its chief executive, "Higher interest rates tested homebuyer sentiment." The release adds that purchasers "remained responsive to incentives that enabled affordability."
| Fiscal 2023 | Fiscal 2022 | Change | |
|---|---|---|---|
| Total revenues | $34.2 billion | $33.7 billion | +1.7% |
| New orders, homes | 69,111 | 61,105 | +13.1% |
| Deliveries, homes | 73,087 | 66,399 | +10.1% |
| Average sales price | $446,000 | $480,000 | −7.1% |
The company took 13.1% more orders for homes and delivered 10.1% more, while its average sales price fell 7.1%. Total revenue still rose 1.7%, because more homes offset the lower price. The release also reports a gross margin of 23.3% on home sales. The figures fit a builder whose buyers face higher mortgage costs and respond to price cuts and other incentives, which is the story in the company's own words. They do not prove it, because the release does not break the fall in the average price into incentives, a different mix of homes and other causes. The pattern is also one company in one year. It shows how the chain from the policy rate to a firm's sales can look, and not how every housing business behaved.
What this lesson leaves out
- Two banks, not all of them. The Fed and the ECB are two of the largest. Other central banks have different mandates, tools and histories, though the ideas carry over.
- The rule is a yardstick. It is a published simplification, not the way either bank decides. The calculator also uses the consumer price index in place of the PCE index the Fed targets.
- Inputs are assumed. The output gap and the neutral real rate are estimates, and the starting settings are chosen for the example, not measured.
- Rates are not the only influence. Wages, energy prices, government borrowing and global events also move inflation and output, and policy acts with delays that this lesson does not model.
- The rate series differ in kind. The Fed figures are monthly averages of the effective rate, and the ECB figures are the deposit rate in force on the last day of the month, so the two columns are not exactly like for like.
- One company is an illustration. Lennar's year shows one possible pattern. It is not a sample of builders.
Common mistakes
Thinking the central bank sets all interest rates
It sets one short-term rate. Mortgage, bond and loan rates move because markets expect what that rate will do, and they can move without a change in it.
Reading the nominal rate as the stance of policy
A policy rate of 4% is tight when inflation is 1% and loose when it is 6%. The real rate, after inflation, is the better guide.
Treating the Taylor rule as a forecast or a law
It depends on two numbers that cannot be observed. Changing them changes the answer, as the third experiment shows.
Expecting an immediate effect
The chain from a rate change to spending, jobs and prices takes time. A rate rise does not lower inflation the next month.
Assuming the two banks have identical goals
The ECB's primary objective is price stability. The Fed has a dual mandate that also includes maximum employment.
Try it yourself
1. Inflation is 3.7%, the output gap is zero and the neutral real rate is 2%. What does the 1993 Taylor rule prescribe?
Show the working
Inflation plus the neutral rate is 3.7 + 2 = 5.70. The response to inflation above 2% is 0.5 × (3.7 − 2) = 0.85. The output gap adds 0.5 × 0 = 0. The total is 6.55%.
2. The Fed's target range is 3.75% to 4.00% and inflation is 3.7%. What is the real policy rate, using the midpoint?
Show the working
The midpoint is (3.75 + 4.00) ÷ 2 = 3.875%. Less inflation of 3.7%, the real rate is 0.18%, which is only slightly above zero.
3. The ECB's deposit rate went from 4.00% on 20 September 2023 to 2.00% on 11 June 2025. How many points is that, and how many separate cuts?
Show the working
4.00 − 2.00 = 2.00 points. The rate table lists eight cuts between those dates, on 12 June, 18 September, 23 October and 18 December 2024, and on 5 February, 12 March, 23 April and 11 June 2025.
4. Lennar's average sales price was $480 thousand in fiscal 2022 and $446 thousand in fiscal 2023. By what percentage did it change?
Show the working
446 ÷ 480 − 1 = −7.1%, a fall of 7.1%.
5. With inflation at 3.7% and no output gap, why does the rule prescribe a very different rate when the neutral real rate is 0.5% and the output gap is −2?
Show the working
Lowering the neutral rate from 2% to 0.5% takes 1.50 points off, and a gap of −2 takes off 0.5 × 2 = 1.00 more. The rule falls from 6.55% to 4.05%, a difference of 2.50 points, from two inputs that cannot be observed directly.
Where this is used
- A company or a household with a variable-rate loan watches the policy rate because its interest cost follows it.
- An analyst discounting future cash flows starts from a rate that depends on what the central bank is expected to do.
- A bank prices its loans and deposits off the policy rate, which is why central bank decisions show up in the margin it earns.
- An investor reads each decision and the words around it for clues about the next one, since longer-term rates move on expectations.
- A homebuilder, car maker or any seller to borrowers watches rates because they affect what customers can afford.
Key terms
- Central bank
- The public institution that sets a short-term interest rate and acts for the monetary system of a country or currency area.
- Monetary policy
- Changing interest rates and the supply of money and credit to influence spending, jobs and prices.
- Dual mandate
- The Fed's two main goals of maximum employment and stable prices.
- Federal funds rate
- The overnight rate at which US banks lend reserve balances to each other, the Fed's main policy rate.
- Deposit facility rate
- The rate the ECB pays banks on money left with it, the key rate tracked in this lesson.
- Real interest rate
- An interest rate after taking away inflation.
- Neutral real rate
- The real rate at which policy neither speeds up nor slows down the economy. It cannot be observed.
- Output gap
- The percentage by which real GDP is above or below an estimate of its potential level.
- Taylor rule
- A formula that links the policy rate to inflation and the output gap.
- Forward guidance
- Public communication about the likely future path of policy.
Questions people ask
Does the central bank control mortgage rates?
Not directly. It sets a short-term rate. Mortgage rates depend on that rate and on what lenders and investors expect it to do over the years of a loan.
Why do both banks aim for 2% inflation and not zero?
Both banks state the 2% figure as their target. The sources used here do not explain the choice, so this lesson leaves the reasoning to the banks' own statements.
Is the Taylor rule what the Fed follows?
No. It is one of several published rules used as a yardstick, and the Atlanta Fed notes that former chairs have preferred other versions.
Why do rates rise when the economy is growing well?
Strong demand can push inflation above target. A higher rate raises borrowing costs, which slows spending and takes pressure off prices.
Sources and review
- Board of Governors of the Federal Reserve System, Monetary policy: what are its goals? How does it work? (page last updated 29 July 2021), for the Fed’s goals, the 2 percent PCE objective, its tools and the way a rate change spreads.
- Board of Governors of the Federal Reserve System, Federal Reserve issues FOMC statement (16 September 2026), for the decision, the vote and the description of inflation and activity.
- Board of Governors of the Federal Reserve System, Federal funds effective rate (FEDFUNDS), percent, monthly, as published by the Federal Reserve Bank of St. Louis (last updated 1 October 2026), for the monthly averages in the rate table.
- European Central Bank, Key ECB interest rates, for the three key rates and the dates and sizes of changes to the deposit facility rate since 2022.
- European Central Bank, The ECB’s monetary policy strategy statement (2025) (30 June 2025), for the price stability objective, the two per cent target and its symmetry.
- Federal Reserve Bank of Atlanta, Taylor Rule Utility, for the form of the rule, the 0.5 weight on the gap, the 2 percent neutral rate and its caveats.
- Lennar Corporation, Fourth quarter and fiscal 2023 results release (Form 8-K, Exhibit 99.1, 14 December 2023), for revenues, new orders, deliveries, average sales price, gross margin and the quotations.
- US Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers (CPI-U), Table 1, September 2026 (released 14 October 2026), for the relative importance of food, energy and all items less food and energy in August 2026 and the 12-month changes to September 2026.
How the numbers were checked: the rule's prescription, each step of it, the real policy rate and the gap to the Fed's midpoint were recomputed in plain code for every combination of settings the calculator allows, and the ECB changes, the totals of its rises and cuts, and the Lennar percentage changes were recomputed from the dates and figures in the sources above. The Fed monthly figures are the average effective rate as published on 1 October 2026, and the ECB figures are the deposit facility rate from the ECB's table of key rates.