How Can Interest Rates Rise Even After A Central Bank Cut

Takeaway: Conventional economic wisdom holds that when a central bank cuts interest rates, commercial banks lower their own lending rates to encourage borrowing. However, new research shows that because of how central banks shift market liquidity, rate cuts can actually cause heavily constrained banks to raise loan rates and reduce lending.

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Key Points

• Policy Mechanism: Central banks change interbank interest rates by buying or selling government bonds, which directly alters the total supply of liquid assets available to commercial banks.

• The "Outflow" Factor: A bank’s financial tightness depends on its "outflow fraction"—the proportion of money it lends out that gets spent and deposited into rival banks.

• Divided Responses: While unconstrained banks lower loan rates when the central bank cuts policy rates, maximally constrained banks face higher liquidity pressures, prompting them to raise lending rates instead.

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When central banks lower benchmark interest rates, everyday consumers and business owners expect mortgage rates, credit card offers, and commercial loans to get cheaper. We typically picture monetary policy as a single control knob: turn it down, and borrowing costs drop across the entire economy.

But have you ever wondered why central bank policy cuts don't always trickle down evenly to every borrower? Or why some financial institutions tighten credit even when the central bank is trying to stimulate the economy?

To understand why, economist Tianxi Wang studied how central banks actually move interest rates in practice. Central banks don't simply decree an interest rate; they execute trades—like swapping government bonds for cash reserves—with the private sector.

Wang developed a theoretical model of banking liquidity and tested it using decades of U.S. commercial bank data to see how individual bank characteristics shape their response to monetary policy.

Findings

When a bank issues a loan, it creates new bank deposits. But borrowers don't keep that money sitting around; they spend it. If a borrower buys goods from someone who uses a different bank, those funds flow out of the original bank. To settle the difference, the lending bank must transfer cash reserves or pledge government bonds as collateral to its rivals.

Wang identifies a crucial bank attribute: the "outflow fraction." Banks that lose a large percentage of their newly created money to rival institutions face tight liquidity constraints. To avoid costly shortfalls, these banks must carefully limit their lending relative to their reserves and bond holdings.

Here is where the conventional wisdom breaks down: When a central bank cuts rates by purchasing government bonds, it removes bonds from the market while injecting cash. Because government bonds serve as essential collateral for banks to manage liquidity, retiring them tightens the liquidity constraint for the most vulnerable banks.

For cash-flush, unconstrained banks, a central bank rate cut simply lowers funding costs, so they lower loan rates as expected. But for heavily constrained banks, the extra burden of tighter liquidity constraints outweighs the benefit of cheaper borrowing rates. To offset this strain, these maximally constrained banks raise their lending rates and shrink loan volumes.

Analyzing historical U.S. banking data, Wang confirmed these predictions.

Banks that consistently hold surplus funds lower their lending rates during monetary easing, whereas net-borrowing banks exhibit the opposite, "anomalous" behavior.

Practical Implications

If correct, these findings have major implications for monetary policy. When central banks cut interest rates near zero, liquidity constraints across the banking system become exceptionally tight. Further rate cuts might actually contract lending at vulnerable banks, dampening the intended economic stimulus.

While the model offers strong explanatory power, it primarily evaluates long-run steady states rather than rapid, unexpected policy shocks. Nonetheless, it alerts policymakers that a "one-size-fits-all" view of interest rate policy ignores critical differences in how banks manage daily cash flows.

Learn More

• Paper Title: Bank Liquidity, Interbank-Rate Setting and Heterogeneous Lending Responses

• Author: Tianxi Wang

• Journal: The Economic Journal

• Publication Year: 2025

• URL: https://academic.oup.com/ej/article/136/675/905/8240248

Econ Today Explains

Economic Concept: Outflow Fraction

The outflow fraction refers to the percentage of money a commercial bank lends out that leaves its own balance sheet and lands in deposit accounts at other banks.

When a bank approves a loan, the borrower usually transfers those funds to pay vendors, employees, or sellers. If those recipients bank elsewhere, the lending bank suffers a cash outflow and must transfer reserves to rival banks to settle the transaction.

Banks with a high outflow fraction face constant liquidity risks, making them far more dependent on cash reserves and government bonds to stay afloat than banks with dominant market shares that retain most deposits internally.

This article was written by AI but reviewed by a real human.