The transmission mechanism
The term transmission mechanism refers to the way in which changes in the repo rate affect inflation and the rest of the economy. In actual fact, the transmission mechanism consists of several different interacting mechanisms. Some of these act on inflation more or less immediately while others take longer to have an effect. It is generally held that a change in the repo rate has its greatest impact on inflation after one to two years.
An adjustment of the repo rate has a direct effect on the shortest market rate, known as the overnight rate. This is the interest rate at which banks can normally finance a liquidity deficit or invest a liquidity surplus. The quantitative effect that a change in the repo rate has on other interest rates depends on how expected the adjustment is. The Riksbank aims to make its monetary policy predictable. By way of speeches and other communication, the Riksbank tries to influence expectations of future monetary policy. This way, unexpected changes in the repo rate can be avoided.
Banks’ lending rates and interest rates on securities are affected therefore by both the actual and expected repo rate. If a hike in the repo rate is fully expected, market rates can begin to rise before the repo rate itself is raised. Then, when the repo rate is actually raised, it will not necessarily have any further effect on market rates if it merely confirms market expectations.
Outline of the transmission mechanism of monetary policy
Through the repo rate, monetary policy influences the interest rates that apply for the public and thereby also aggregate demand and resource utilisation in the economy. The channels through which market interest rates affect resource utilisation can be categorised in different ways, but channels that are generally considered important for monetary policy are the interest rate channel, the credit channel and the exchange rate channel. You can read more about these channels by clicking on the relevant link on the left. There you can also read more about the role of inflation expectations in monetary policy analysis.
A more in-depth description of the transmission mechanism can be found in the below article. More information about how a repo rate change is implemented in practice can be found under the link The monetary policy framework.