How Interest Rates Affect Financial Markets?

An interest rate is the cost of borrowing money, or the return earned on savings, typically expressed as a percentage. Central banks set a benchmark interest rate — often referred to as the policy rate or base rate — which influences interest rates throughout the broader economy, including those offered by commercial banks.

Central banks adjust their benchmark interest rate as a tool for managing economic conditions, particularly inflation and employment. Raising rates generally makes borrowing more expensive and saving more attractive, which can help slow down an overheating economy or address high inflation. Lowering rates generally has the opposite effect, encouraging borrowing and spending, often used to support a slowing economy.

Interest rates influence the relative appeal of holding a currency. Higher interest rates can make a currency more attractive to certain investors seeking better returns on currency-denominated assets, all else being equal, while lower rates can have the opposite effect. This is one reason why interest rate decisions and expectations are closely tied to currency market movements.

It's important to note that interest rates are just one of many factors influencing currency values, and their effect can be influenced by broader market conditions, expectations, and other simultaneous economic developments.

As with other scheduled economic events, markets often react not just to the interest rate decision itself, but to how it compares with expectations, and to any forward guidance provided about future policy direction. A rate decision that matches expectations may generate a smaller reaction than one that surprises the market, or one accompanied by an unexpected shift in tone regarding future policy.