What it means
In normal times, a central bank steers the economy by moving a short-term policy interest rate. Lower rates make borrowing cheaper and encourage spending, while higher rates cool demand.
This is the standard toolkit. The standard tool has a limit.
When rates fall close to zero, there is little room to cut further, yet the economy may still need support, as happened after the 2008 financial crisis and during the pandemic. Central banks then turn to non-standard measures to ease financial conditions in other ways.
The best-known measure is large-scale asset purchases, often called quantitative easing, where the central bank creates money to buy government bonds and sometimes other assets. This pushes up their prices, lowers longer-term yields and encourages banks and investors to lend and invest more.
Other tools include negative policy rates, cheap long-term loans to banks, and forward guidance, which is a promise about how long rates will stay low. The effects reach businesses in several ways.
Lower long-term interest rates reduce the cost of borrowing for mortgages and corporate bonds, higher asset prices raise the value of pensions and investments, and a weaker currency can help exporters. They can also reduce returns for savers and push investors into riskier assets.
There are risks and trade-offs. Large balance sheets can be difficult to unwind, prolonged low rates may encourage excessive debt, and the benefits tend to reach asset owners first.
Critics also worry about the central bank's independence if it buys too much government debt. For finance teams, the practical lesson is to model different interest rate paths and plan for periods when rates are far from historical norms.
Debt pricing, hedging decisions and investment hurdle rates all depend on the assumed rate environment.
In practice
Real-world examples.
Example
A central bank cuts its policy rate to zero but inflation stays below target. It announces a programme to buy $50 billion of government bonds a month, which pushes down long-term yields and lowers mortgage rates. Home buyers see lower monthly payments, and builders find it easier to finance new projects.
Example
A bank in a country with negative policy rates is charged for holding excess reserves at the central bank. Corporate treasurers there find that some banks charge fees on large deposits, so they spread cash across several institutions. Some companies also pay suppliers earlier rather than hold idle balances.
Example
A manufacturer plans a $10,000,000 expansion after the central bank signals through forward guidance that rates will stay low for at least two years. The finance team locks in a fixed-rate loan while the guidance supports low yields. The fixed rate gives the company a stable interest cost for the life of the project.
Formula
Calculation
Central bank balance sheet after purchases = Starting balance sheet + (Monthly purchases x Number of months)
Suppose a central bank starts with a balance sheet of $1,000 billion and announces purchases of $20 billion of bonds a month for 12 months. Total purchases = $20 billion x 12 = $240 billion. New balance sheet = $1,000 billion + $240 billion = $1,240 billion, an increase of $240 billion / $1,000 billion = 24%. If the bonds bought have an average yield of 3% a year, the bank would earn about $240 billion x 0.03 = $7.2 billion a year on the new holdings.Case study
Seen in the real world.
Calder Industrial is a fictional equipment manufacturer invented to illustrate this idea. Its home country faced weak growth and a policy rate already at zero, so the central bank began buying government and corporate bonds in large volumes.
Calder's treasurer saw the yield on the company's bonds fall from 4% to 2.5% within a year. She refinanced $50,000,000 of debt, saving $50,000,000 x 1.5% = $750,000 a year in interest.
She also warned the board that the savings might not last, because the central bank had signalled it would eventually reduce its purchases. Calder therefore fixed the rate on part of the new debt and kept the rest floating, balancing certainty against flexibility. The board approved the plan after seeing a stress test with rates two percentage points higher.
Watch out
Common mistakes.
- Treating quantitative easing as the same as printing cash for the public. The central bank creates reserves to buy assets, and the money does not go to households directly.
- Assuming low rates will last forever. Policy can change, and financing plans should consider a return to higher rates.
- Believing non-standard policy only helps borrowers. Savers and pension funds can be hurt by persistently low yields.
Questions
People also ask.
Why do central banks use non-standard measures?
They turn to them when the main interest rate is near its lower limit and cannot be cut further.
Is non-standard policy permanent?
No. Central banks generally intend to reverse or reduce such measures as conditions improve, though timing can be uncertain.
How does it affect a business?
It changes borrowing costs, asset prices, exchange rates and bank lending conditions, which all feed into investment and financing decisions.
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