Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Pass-Through of Policy Rates
Transcript
- Lucas: So the European Central Bank raises rates by 25 basis points. A few hours later, the news is everywhere. But here's the question that actually matters for the real economy: how long does it take for that 25 basis points to show up in the loan rate your local bakery pays on its credit line? Luna: And the answer, depending on where you live and how your banking system works, could be anywhere from a month to over a year. Lucas: Exactly. This is the pass-through of policy rates—the core transmission mechanism from a central bank's decision to actual borrowing costs in the economy. And it is much less automatic than most people assume. Luna: I remember reading a 2024 paper from the Bank for International Settlements that looked at this. They found that in the euro area, only about 40 percent of a rate change passes through to bank lending rates within the first quarter. In the United States, it's closer to 70 percent. Lucas: That's a huge difference. And it matters because if pass-through is sluggish, the central bank has to push rates further or wait longer to get the same effect. So why the gap? A lot of it comes down to the structure of the mortgage market. Luna: Right. In the US, the vast majority of mortgages are 30-year fixed rate. And those are held in mortgage-backed securities, not on bank balance sheets. So when the Fed raises rates, new mortgages get more expensive, but the entire existing stock is locked in. That slows the pass-through to household spending. Lucas: Meanwhile, in countries like the UK or Australia, most mortgages are floating-rate or fixed for only two to five years. So a rate hike hits households much faster. The Bank of England has estimated that around 70 percent of the impact of its rate changes on household cash flow occurs within 12 months. Luna: That's a much faster transmission. But even within the same country, pass-through can vary by loan type. Commercial loans tend to reprice faster than mortgages because they're often linked to SOFR or overnight index swaps. Lucas: And then there's the question of bank competition. If a few large banks dominate the market, they might absorb part of the rate change into their net interest margin rather than passing it through to borrowers. That's been a big debate in Canada, where the big five banks control over 80 percent of lending. Luna: There was a report from the Bank of Canada in 2025 that showed pass-through had actually declined in the prior cycle. They attributed it to banks using the rate hiking cycle to widen spreads, especially on variable-rate mortgages. Lucas: Which is a polite way of saying they pocketed some of the hike instead of passing it on. That frustrates central bankers, because they're trying to tighten conditions, and the banks are acting as a shock absorber. Luna: But wait—isn't that exactly what central banks want? A smooth transmission, not a jolt? Lucas: To a point, yes. But if the pass-through is too weak, the central bank has to raise rates higher than it otherwise would, which can eventually cause a sharp correction when the pass-through finally kicks in. That's the risk of a clogged transmission belt. Luna: It reminds me of the 2023 banking turmoil in the US. The rapid rise in rates hit some banks' bond portfolios hard, but the pass-through to lending was actually quite slow because many banks had locked in low-rate loans. Lucas: Right. And that's where the non-bank lending sector comes in. Private credit funds, direct lenders, fintech platforms—they repriced much faster. By mid-2023, some middle-market direct lenders were already quoting rates that reflected the full Fed hike, while traditional banks were still undercutting them on relationship loans. Luna: So the pass-through is becoming more fragmented. A small business that borrows from a fintech might feel the rate hike in weeks, while one that borrows from a community bank might not feel it for months. Lucas: Exactly. And that has implications for how central banks communicate. The Fed and the ECB now talk explicitly about pass-through in their policy statements. The Bank of England even publishes a 'pass-through indicator' in its quarterly Monetary Policy Report. Luna: What does that indicator actually measure? Lucas: It's a composite of several sub-measures: the speed at which new mortgage rates adjust, the proportion of loans linked to the bank rate, and the average spread between the bank rate and actual lending rates. As of mid-2026, that indicator is showing that pass-through has been faster in the current tightening cycle than in the 2000s, but still slower than in the 1990s. Luna: So we're living in a medium-speed transmission economy. Not instant, not glacial. Lucas: And that's partly by design. Since the global financial crisis, regulators have encouraged banks to hold more stable funding and use fixed-rate lending to reduce fire-sale risks. That has the side effect of slowing the pass-through. Luna: It's a trade-off. Financial stability versus the speed of monetary policy. Lucas: One area where pass-through is very direct, though, is in deposit rates. Banks are notoriously slow to raise deposit rates even when policy rates go up. In the US, the deposit beta—how much of a rate hike passes to savers—was around 30 percent in the 2022-2023 cycle. Luna: That means for a five percent Fed funds rate, the average savings account was yielding maybe one-point-five percent. That's a huge margin for banks. Lucas: And that margin is essentially a subsidy from depositors to bank shareholders. It's one reason bank profits surged during the hiking cycle. But it also means that the pass-through to the broader economy is weaker than the rate hikes alone would suggest. Luna: So if you're trying to gauge where the economy is heading, just looking at the policy rate isn't enough. You need to look at the actual rates being paid by borrowers and received by savers. Lucas: And that's why central banks now spend a lot of time studying 'effective financing conditions'—a broader measure that includes loan rates, bond yields, equity costs, and even credit availability. The ECB publishes a Composite Indicator of Financing Conditions each month. Luna: It sounds like pass-through is becoming a more active area of research again, especially as the banking system evolves. Lucas: It really is. And one of the newer angles is looking at how non-bank intermediaries affect pass-through. For example, when a rate hike reduces the value of bond holdings, that can force asset managers to sell, which tightens conditions further—even if banks haven't changed their rates. Luna: That's the market-based pass-through channel. It's faster and less predictable than the bank-based one. Lucas: And it's gotten more important as the share of non-bank credit has grown. In the US, non-banks now account for roughly half of all mortgage origination and a growing share of corporate lending. Luna: So the old model—where a central bank moves a lever and the whole economy adjusts in a predictable way—is increasingly outdated. The transmission belt has more gears and more slippage. Lucas: That's the honest truth. And it's a big reason why central bankers are so cautious. They know that their tools work, but they don't always know how quickly or how evenly. Luna: If walking through the economy with us has made something click, there's a way to keep these conversations going ad-free. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. Lucas: Yeah, it's a small community, but it makes a real difference. We don't run ads, so listener support is what keeps us independent. Luna: And we're grateful. Now, back to that pass-through puzzle—one thing I find fascinating is how central banks try to measure it in real time. The New York Fed has a 'pass-through dashboard' that updates weekly. Lucas: I didn't know that. What does it show? Luna: It tracks the spread between the effective federal funds rate and rates on new auto loans, credit cards, and small business loans. As of late June 2026, the spread on auto loans was actually wider than the historical average, suggesting that pass-through to that segment has been slower. Lucas: That might reflect competition from captive finance companies—the auto manufacturers' own lending arms—which can offer below-market rates to move inventory. Luna: Exactly. So even within a single loan category, pass-through can be uneven. It's a granular picture, but it helps explain why the aggregate numbers can be misleading. Lucas: And that's the takeaway: the policy rate is the headline, but the pass-through rate is the story. Next time you hear about a rate hike, ask yourself—how fast will this reach my bank account? The answer tells you more than the rate itself. Luna: And whether you're a borrower or a saver, that's the number that really matters.