How does a central bank move markets?
Three tools. One is a dial, one is a firehose, one is a sentence. Markets react to all three — sometimes most violently to the sentence.
Tool 1: the policy rate (the dial)
The classic instrument you met in Unit 1: raise the rate to cool spending and inflation, cut it to stimulate. Turning the dial reprices every loan and — through the gravity effect — every asset. Slow, powerful, blunt.
Tool 2: buying and selling bonds (the firehose)
When rates hit zero during crises and can't go meaningfully lower, central banks turn to quantitative easing (QE): creating new central-bank money to buy government (and sometimes corporate) bonds at scale. The buying pushes bond prices up and long-term yields down — stimulus beyond the dial's reach. The reverse — letting those holdings shrink, called quantitative tightening (QT) — quietly drains the tub. After 2008 and again in 2020, QE moved from emergency experiment to standard equipment, leaving central banks holding trillions on their balance sheets — a fact that still shapes bond markets years later.
Tool 3: forward guidance (the sentence)
Markets price the FUTURE (Course 2's deepest lesson) — so a credible statement about future policy moves prices today, before anything is actually done. "Rates will stay low for an extended period" eases conditions the moment it's spoken. This is forward guidance: policy conducted through vocabulary. Its entire power runs on credibility — a central bank caught bluffing loses the tool — which is why every syllable is drafted like a legal document and parsed like scripture.
The market-reaction cheat sheet
Easier policy (cuts, QE, dovish words) → bond yields tend down, stocks tend up, currency tends weaker. Tighter policy (hikes, QT, hawkish words) → the mirror image. Real life adds exceptions — but this is the baseline grammar of every central-bank headline you'll ever read.
In the data
Whether the firehose is on or off shows up in funding markets, as spreads between overnight rates quoted in basis points. Here is one of them over five days: the effective federal funds rate, which banks charge each other unsecured, against SOFR, the rate on overnight loans secured by Treasuries.
A spread like this is not a price anybody quoted; it is one published rate minus another, and the table shows both legs beside it. That is what lets you check which leg moved, and it matters: a spread that widened because one rate spiked is a different event from one that widened because the other collapsed.
Try it now
Explain to an imaginary friend why WORDS can move markets before any action — which Course 2 idea powers this?
Take the spread apart instead of trusting it. On the newest day in the table above, compute the difference between the two rates yourself, convert to basis points, and check it against the spread printed beside them. It matches — and now you know the number is a subtraction rather than a price anybody quoted.
Now find the widest of the five days, reading the sign as well as the size. Then look at which leg moved to get there: a spread that widened because one rate spiked is a different event from one that widened because the other collapsed, and the single headline number cannot tell you which happened.
Classify as easing or tightening: a surprise rate cut · balance-sheet runoff begins · "we are prepared to act forcefully."