1. Why interest rates exist at all

In the chapter Time value of money & discount factors, three forces were introduced that explain why a euro today is worth more than a euro in the future: opportunity cost (money available now can be invested), inflation (prices tend to rise, eroding purchasing power), and uncertainty (a future payment is never as sure as cash in hand). Together they explain why lenders demand compensation and borrowers must pay interest. Those same forces now serve as the starting point for understanding what moves interest rates across time and across economies.

This chapter shifts the lens from individual cash flows to the macroeconomic environment. Why does the interest rate change from one year to the next? Why does it differ between the eurozone and the United States? What determines whether the euro strengthens or weakens against the dollar? The answers lie in central bank policy, inflation dynamics, economic growth, and the interplay between them.

2. Real rates, nominal rates, and the Fisher equation

2.1 Why this distinction matters

The distinction between real and nominal interest rates is one of the most important in macroeconomics, because almost every economic decision depends on which one you look at.

The nominal interest rate is the rate quoted in the market: the number printed on a loan agreement, displayed on a bond screen, or announced by a central bank. It is expressed in money terms and makes no adjustment for inflation.

The real interest rate is what the lender actually earns, or what the borrower actually pays, in terms of purchasing power. If you earn 4% on a deposit but prices rise by 3%, your real gain is only about 1%. You have more euros, but each euro buys less.

This matters because economists typically assume that economic behaviour responds to real rates, not nominal ones. A rational household deciding whether to save or spend compares the real return on savings to the cost of goods today versus tomorrow. When real rates are high, saving is attractive and borrowing is expensive, which cools the economy. When real rates are low or negative, saving is penalised and borrowing is cheap, which stimulates spending. Central banks ultimately aim to influence real rates, even though they set nominal ones.

The Fisher equation, named after the American economist Irving Fisher, captures the relationship:

2.2 Negative real rates

Real rates can turn negative when nominal rates are low and inflation is high, or when nominal rates themselves are negative. When real rates are negative, borrowers are effectively being subsidised: they repay less in purchasing power terms than they received. For savers, the opposite holds: their money is losing real value even while it may earn a positive nominal return.

Negative real rates are not a recent or temporary phenomenon. A 2019 study by Bruegel, the Brussels-based economic think tank, documented that long-term real interest rates had fallen below zero in every single euro area country. Germany was the first to cross the threshold, in September 2011. Spain followed in July 2016, then Italy in August 2019, and finally Greece in September 2019. By September 2019, Germany’s 10-year real government bond yield had fallen to approximately -2.7% per year. At that rate, a bondholder’s real wealth erodes by roughly a quarter over a decade. Nine additional euro area countries had real rates at or below -2%.

This was not driven by an inflation surge. In the pre-COVID period, nominal yields had fallen further and faster than inflation expectations, pushing real rates deeply negative. The ECB’s quantitative easing programmes and negative deposit rate compressed nominal yields across the continent. The signal was clear: monetary conditions were extraordinarily loose, and the real return on safe assets had turned punitive for savers.

The post-COVID period added a different dynamic. Between 2021 and 2022, inflation surged while policy rates initially remained near zero. Real rates became even more negative through the other channel: inflation running well above the nominal rate. This combination sent a powerful signal that central banks were behind the curve, and it ultimately triggered the fastest hiking cycle in decades.

When real rates are deeply negative for a prolonged period, it typically signals one of two things: either a central bank is deliberately maintaining very easy financial conditions to stimulate growth or prevent deflation, or an inflation shock has outpaced the policy response. Understanding which regime you are in matters enormously for investment and hedging decisions. In the first regime, negative real rates are likely to persist: locking in fixed-rate borrowing is attractive, and there is little urgency to hedge against rate rises. In the second, deeply negative real rates are a temporary distortion before an inevitable hiking cycle. A treasurer who has not yet locked in borrowing costs faces a sharp repricing, and the longer they wait, the more the market will have priced in the coming moves, making hedges progressively more expensive.

2.3 Measuring real rates: inflation-linked bonds

Real rates are not directly quoted on a screen in the way nominal rates are. They must be inferred. The most direct market-based method uses inflation-linked bonds.

In the United States, the Treasury issues Treasury Inflation-Protected Securities (TIPS). A TIPS bond pays a fixed real coupon, but its principal is adjusted upward over time in line with realised CPI inflation. If inflation turns out to be high, the investor receives more; if low, less. The yield on a TIPS therefore represents a real rate of return: the compensation investors demand above and beyond inflation.

In the eurozone, inflation-linked bonds such as French OATi (indexed to French CPI) and German inflation-linked Bunds (indexed to eurozone HICP) serve the same function.

Because the yield on an inflation-linked bond is a real yield, these instruments give the most direct market-based reading of real interest rates at various maturities. As we will see in section 8, comparing these real yields to nominal bond yields also provides a powerful measure of inflation expectations.

3. Central banks: mandates and the policy rate

3.1 The main central banks

Three central banks have the greatest influence on global interest rate markets.

The European Central Bank (ECB) is the monetary authority for the 20 countries that use the euro. Its mandate is focused on a single objective: price stability, defined as a symmetric 2% inflation target over the medium term. The ECB revised its strategy in July 2021, explicitly adopting this symmetric formulation and dropping the previous “close to but below” language. The ECB does not have an explicit mandate to support employment or growth.

The Federal Reserve (Fed) is the central bank of the United States. Unlike the ECB, the Fed operates under a dual mandate: it is required by law to pursue both price stability (targeting 2% average inflation) and maximum employment. This means the Fed must weigh the trade-off between fighting inflation and supporting the labour market. In practice this makes Fed communication more nuanced, since a rate decision is always a judgement call between two competing objectives.

The Bank of England (BoE) operates under a mandate set by the UK government. Its primary objective is price stability, with a 2% CPI target. It has a secondary objective to support the government’s economic policy, including employment. In structure, it sits between the single-mandate ECB and the dual-mandate Fed.

3.2 The policy rate: the central bank’s main lever

Each central bank sets a key short-term interest rate, the policy rate, that serves as the anchor for borrowing costs across the economy. This rate is the overnight rate at which commercial banks can borrow from or deposit with the central bank.

For the ECB, the relevant rate is the deposit facility rate: the rate at which banks park excess reserves at the ECB overnight. For the Fed, it is the federal funds rate: the rate at which banks lend reserves to each other overnight. For the BoE, it is the Bank Rate.

These overnight rates act as a floor for the entire interest rate system. If a bank can earn, say, 3% overnight by depositing cash at the central bank risk-free, it will not lend to another bank for less. The policy rate therefore sets the bottom of the rate structure, and all other rates, on loans, mortgages, bonds, and derivatives, are priced in relation to it.

4. How central banks influence rates

4.1 The policy rate

Raising or lowering the policy rate is the primary tool. Central banks typically adjust it in discrete steps of 25 basis points (0.25%). A 25bp move is considered a standard, measured adjustment. In periods of urgency, a central bank may opt for a 50bp move to signal stronger conviction, or even 75bp in exceptional circumstances, as the Fed did three times in 2022. The size of the move matters: a larger-than-expected step signals that the central bank views the situation as more serious than the market had priced in, which can trigger sharp reactions across bond, swap, and FX markets.

Central banks have several mechanisms to implement and enforce their policy rate target. These include open market operations (buying or selling government bonds to add or withdraw reserves from the banking system), standing facilities (such as the ECB’s deposit facility, where banks can park excess reserves at the announced rate), and interest on reserves (paying banks a set rate on their reserve balances, which anchors the overnight rate from below). The mix varies by central bank and has evolved over time, but the effect is the same: the central bank controls the short-term interest rate at which banks transact with each other overnight.

4.2 Forward guidance

Beyond the policy rate itself, central banks use additional tools to influence broader financial conditions. The first is forward guidance: communication about the likely future path of the policy rate. Because financial markets are forward-looking, investors price today’s long-term rates based partly on where they expect short rates to go in the future. By clearly signalling its intentions, the central bank can shift longer-term rates without actually moving the policy rate immediately.

When the ECB said in 2013 that it expected rates to remain low for an “extended period”, it was attempting to keep borrowing costs down by anchoring rate expectations, not by cutting rates further. Forward guidance became increasingly important as rates hit their lower bounds.

4.3 Quantitative easing

When the policy rate has been cut to near zero and further cuts are not possible or effective, central banks can use quantitative easing (QE), the large-scale purchase of financial assets (typically government bonds, and sometimes corporate bonds or other instruments) directly from the market.

QE pushes down yields on the assets purchased and, by extension, on a broad range of longer-term rates. The channels are multiple: it directly reduces the supply of bonds available to the market (pushing prices up and yields down), signals that rates will remain low for longer, and encourages investors to shift into riskier assets, easing financing conditions for businesses and households.

The ECB, the Fed, and the BoE deployed QE extensively after the 2008 financial crisis and again during the COVID-19 pandemic, then partially reversed it during the subsequent inflation episode.

5. Sticky prices and taming inflation

When a central bank raises rates, the effect on the broader economy does not arrive instantly. The path from a policy rate decision to its effect on inflation involves several steps, and the process takes time.

Higher policy rates raise the cost of overnight borrowing for banks. Banks pass this on through higher lending rates for mortgages, business loans, and consumer credit. Higher borrowing costs reduce demand: households spend less, companies invest less, and activity slows. Lower demand eventually reduces upward pressure on prices.

The key friction in this process is that prices are sticky: they do not adjust instantly to changes in demand. A supermarket does not immediately cut prices because interest rates went up. A services firm does not reduce its prices the day after a rate hike. Prices tend to respond slowly, especially downward. Wages are even stickier: workers resist pay cuts and employment contracts run for extended periods.

This stickiness means that monetary policy works with long and variable lags. The ECB and Fed typically estimate that rate changes take 12 to 18 months or more to exert their full effect on inflation. A central bank raising rates today is fighting the inflation of next year, not of this month. This makes central banking inherently forward-looking and explains why policy decisions are based heavily on forecasts and expectations rather than current data alone.

6. Economic growth, GDP, and long-term rates

6.1 What GDP measures

Gross domestic product (GDP) is the total value of all goods and services produced in an economy over a given period, typically a quarter or a year. It is the broadest single measure of economic activity.

Like interest rates, GDP comes in a nominal and a real flavour:

• Nominal GDP measures output at current prices. If the economy produces the same goods as last year but prices have risen 5%, nominal GDP grows by 5% even though no additional physical output was created.
• Real GDP strips out the effect of price changes and measures economic growth in actual output. It is calculated by valuing goods and services at constant (base-year) prices.

The distinction mirrors the nominal-versus-real split in interest rates. A country reporting 6% nominal GDP growth with 4% inflation has only achieved 2% real growth. It is real GDP growth that matters for living standards, employment, and long-term prosperity, and it is real GDP growth that central banks and bond markets focus on.

When real GDP contracts, the economy is shrinking. A recession is commonly defined as two consecutive quarters of negative real GDP growth. Recessions are typically accompanied by rising unemployment, falling corporate earnings, and weaker demand. They matter for interest rate markets because central banks usually respond by cutting rates to support the economy, which in turn affects the pricing of every bond, swap, and hedge.

6.2 How growth expectations feed into long-term rates

Short-term rates are largely controlled by central banks. But longer-term rates, for example the yield on a 10-year government bond, are set by the market. Investors buying a 10-year bond form a view about where short rates will be over the next ten years and demand a return consistent with that expectation.

When economic growth is expected to be strong, the market anticipates that central banks will keep rates higher for longer to prevent overheating. Long-term yields rise. When growth is expected to be weak, rate expectations fall and long-term yields decline.

Inflation expectations and growth expectations are often connected. A booming economy generates wage pressure and higher demand for goods, which feeds inflation. A weak economy drags inflation down. The 10-year government bond yield therefore reflects the market’s joint assessment of future growth and future inflation, mediated through expectations about central bank policy.

7. Stagflation: when growth and inflation move in opposite directions

The connection between growth and inflation described above, strong growth fuelling inflation, weak growth dragging it down, holds most of the time. But not always. Stagflation is the uncomfortable combination of stagnant economic growth (or outright recession) and high inflation occurring simultaneously. It breaks the usual pattern and puts central banks in an impossible position: raising rates to fight inflation risks deepening the downturn, while cutting rates to support growth risks letting inflation spiral further.

7.1 The 1970s: the textbook episode

The most prominent episode of stagflation occurred in the 1970s, triggered by two major oil price shocks. In 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo in response to Western support for Israel during the Yom Kippur War. Oil prices roughly quadrupled in a matter of months. A second shock followed in 1979, when the Iranian Revolution disrupted oil supply and prices doubled again.

The effect was devastating. Energy is an input to virtually every sector of the economy. Soaring oil prices simultaneously raised production costs (pushing inflation up) and reduced real incomes for consumers and businesses (dragging growth down). The United States experienced inflation above 12% alongside rising unemployment and two recessions within three years. Europe was hit even harder, given its greater dependence on imported oil.

Central banks initially struggled to respond. The Fed, under Chairman Arthur Burns, was reluctant to raise rates aggressively for fear of worsening unemployment. The result was that inflation became entrenched and expectations de-anchored. It took the appointment of Paul Volcker as Fed Chairman in 1979 and a brutal tightening cycle, with the federal funds rate reaching over 20%, to finally break inflationary expectations. The cost was a severe recession in 1981-1982, but the episode re-established central bank credibility and ushered in decades of more stable inflation.

The 1970s stagflation left a lasting mark on central banking doctrine. It demonstrated that tolerating inflation in the hope of protecting growth can make both problems worse, and that credibility, once lost, is expensive to rebuild.

7.2 Supply shocks: the common thread

Stagflation is almost always caused by a supply shock rather than a demand shock. In a demand-driven downturn, falling demand pulls both growth and inflation down together, and rate cuts can help. But when the shock comes from the supply side, a sudden increase in the cost of a key input like energy, the economy faces higher prices and lower output at the same time. Monetary policy has no good answer for a supply shock: it can address one side of the problem but not both.

7.3 Modern stagflation risks

The word “stagflation” returned to market commentary in the 2020s. The post-COVID inflation surge initially coincided with strong growth, which made aggressive rate hikes feasible. But the combination of the Ukraine war energy shock, persistent supply chain disruptions, and the subsequent tightening cycle raised genuine stagflation concerns in Europe, where growth slowed sharply while inflation remained elevated through much of 2022-2023.

More recently, escalating conflicts in the Middle East have revived fears of a 1970s-style oil supply disruption. Any sustained conflict that restricts oil flows through the Strait of Hormuz or disrupts major Gulf producers could create the same toxic combination: higher energy costs pushing inflation up while simultaneously choking economic activity. Markets price these risks through higher oil futures, wider breakeven inflation rates, and a flattening or inversion of yield curves, as investors simultaneously expect higher near-term inflation and weaker long-term growth.

For treasury practitioners, stagflation scenarios are particularly challenging. Hedging programmes built on the assumption that rates fall when growth weakens (the normal pattern) can fail badly when inflation keeps rates elevated despite a recession. Understanding that supply shocks can break the usual growth-inflation link is essential for stress-testing any hedging strategy.

8. Measuring inflation & growth

The previous sections introduced inflation and GDP as the two forces that shape the interest rate environment. Central banks respond to them, bond markets price them in, and exchange rates reflect their divergence across economies. But neither inflation nor growth is observed continuously. They are measured through a set of scheduled data releases, each published on a fixed calendar, each with its own methodology. Understanding which ones matter and why requires a distinction that runs through all of them: some indicators tell you where the economy has been, while others give you an early signal of where it is going.

8.1 Backward-looking vs. forward-looking indicators

A backward-looking (or lagging) indicator measures something that has already happened. GDP itself is the clearest example: when the first estimate for Q1 GDP is published, the quarter is already over. The data confirms what occurred but cannot tell you what is happening right now or what comes next. The unemployment rate is another lagging indicator. It tends to rise well after a downturn has begun, because employers are slow to lay off workers, and to fall well after a recovery has started, because hiring follows confidence with a delay.

A forward-looking (or leading) indicator captures activity or sentiment that tends to precede changes in the broader economy. Survey-based measures like PMI ask businesses about their current and expected activity, giving a real-time signal before the hard data arrives. Producer prices can signal shifts in consumer inflation before they show up in the CPI. Employment data, depending on the measure, can sit anywhere on this spectrum.

The distinction matters because markets are forward-looking. A GDP print that confirms what everyone already knew rarely moves bond yields. A PMI release that signals an unexpected turn in the cycle can move them sharply. Traders care less about where the economy is than about where it is going, because central bank policy responds to the outlook, not to the rearview mirror.

8.2 Measuring inflation: CPI, PPI, and PCE

Headline vs. core inflation

Central banks and market participants track inflation using a Consumer Price Index (CPI), a basket of goods and services representative of typical household consumption.

Headline inflation is the change in the full basket, including food and energy. It reflects the inflation that households actually experience but is volatile, since energy and food prices can swing sharply due to harvests, geopolitical events, or commodity cycles.

Core inflation strips out food and energy and focuses on the underlying trend. It is less volatile and gives a cleaner read on persistent inflationary pressures. Central banks pay close attention to core inflation when setting policy because they cannot easily influence global energy or food prices directly.

CPI

CPI (Consumer Price Index) measures price changes at the retail level: what households pay for goods and services. It is the headline inflation number in most countries and the measure that the ECB targets. CPI is published monthly in the eurozone (by Eurostat, where it is called HICP) and in the United States (by the Bureau of Labor Statistics). Because it measures final prices to consumers, CPI is inherently a backward-looking indicator. It tells you what inflation was last month.

PPI

PPI (Producer Price Index) measures price changes at the factory gate or wholesale level: what producers receive for their output before goods reach consumers. PPI matters because cost pressures at the producer level tend to feed through to consumer prices with a lag. When raw material costs and manufacturing prices rise, companies eventually pass those increases on to consumers. When producer prices fall, it often signals that consumer inflation will moderate in the months ahead. In this sense, PPI is more forward-looking than CPI for the trajectory of consumer inflation, even though it is itself a backward-looking measure of producer prices.

The gap between PPI and CPI can also indicate margin pressure. When PPI rises faster than CPI, producers are absorbing costs. When CPI catches up, margins are being restored through price increases.

PCE

PCE (Personal Consumption Expenditures Price Index) is specific to the United States. It is published by the Bureau of Economic Analysis and is the inflation measure that the Federal Reserve officially targets.

PCE differs from CPI in two important ways. First, its weighting methodology allows for substitution: if beef becomes expensive and consumers switch to chicken, PCE adjusts the weights to reflect actual purchasing behaviour, while CPI keeps the original basket fixed until the next rebase. Second, the coverage is broader. PCE includes spending on behalf of consumers (such as employer-paid health insurance) that CPI excludes. As a result, PCE inflation tends to run slightly below CPI inflation.

When the Fed says it targets 2% inflation, it means 2% on the PCE measure, and more specifically on core PCE, which excludes food and energy. Traders following the Fed therefore watch core PCE closely, even though CPI gets the bigger headlines.

PPI vs. CPI in practice: volatility and lag

The chart below plots three eurozone inflation measures side by side from March 2017 to February 2026: PPI year-on-year (left axis), headline CPI year-on-year (right axis), and core CPI year-on-year (right axis). Two separate axes are used, one for PPI and another for CPI, because the scales are very different.

Two patterns stand out.

PPI is far more volatile than CPI, which is itself more volatile than core CPI. Over this period, PPI moved across a range of more than 50 percentage points (from -10.3% to +40.3%). Headline CPI moved across about 11 percentage points (from -0.3% to +10.6%). Core CPI, by design, was the steadiest of the three, moving across only about 5.5 percentage points (from +0.2% to +5.7%). This is not surprising. PPI is dominated by energy and commodity prices, which are inherently volatile. Headline CPI passes some of that volatility through to consumers. Core CPI strips it out entirely. Between 2017 and 2020, before the inflation shock, this contrast was already visible: PPI swung between +5% and -5% while core CPI barely moved, hovering in a narrow band between 0.2% and 1.3%.

PPI usually leads CPI by several months. The 2021-2023 inflation episode makes the cascade visible. As supply chains seized up and energy prices surged after Russia’s invasion of Ukraine in February 2022, PPI was the first to react. It had already been climbing since early 2021 and reached its peak of 40.3% in August 2022. Headline CPI, which reflects the prices consumers actually pay, peaked two months later at 10.6% in October 2022. Core CPI, which filters out the direct energy and food effects and captures only the slower-moving pass-through into services, wages, and other sticky categories, peaked last at 5.7% in March 2023, a full seven months after PPI.

The lag is even more striking on the way down. By May 2023, PPI had already crossed into negative territory (-0.9%), meaning producer prices were falling year-on-year. At that same moment, headline CPI was still at 6.1% and core CPI was at 5.3%. The disinflationary signal had already arrived at the factory gate, but it had not yet reached the supermarket shelf or the services sector.

This lead-lag relationship is the reason traders watch PPI closely even though central banks target CPI or PCE. A sharp move in PPI today is a preview of where consumer inflation is likely heading in the months ahead. It does not tell you exactly when or by how much (the transmission depends on margins, demand conditions, and wage dynamics), but it narrows the range of plausible outcomes for the CPI prints that central banks will be reacting to.

8.3 Wage inflation

A particular concern for central banks is wage inflation, the rate at which wages are rising across the economy. Wages are the main cost for most service businesses. When wages rise faster than productivity, companies pass those costs on as higher prices, leading to higher goods and services inflation, which then prompts workers to demand higher wages in turn. This wage-price spiral can make inflation self-sustaining and is one of the hardest dynamics to break without significant rate increases.

Wage inflation tends to be sticky. Once workers receive higher wages, they are reluctant to accept cuts. This is one reason why inflation, once embedded, takes time and pain to remove.

8.4 Market-implied inflation expectations: breakeven rates and inflation swaps

Beyond the current CPI print discussed in section 8.2, investors and central banks watch carefully where the market expects inflation to go in the future. The two main market-based measures are breakeven inflation rates and inflation swaps.

Breakeven inflation rates

Section 2 introduced inflation-linked bonds as a way to measure real interest rates. Those same bonds also provide the most widely used market-based measure of inflation expectations.

The breakeven inflation rate is the difference between the yield on a standard (nominal) government bond and the yield on an inflation-linked bond of the same maturity:

If the 10-year nominal Bund yields 2.5% and the 10-year inflation-linked Bund yields 0.2%, the breakeven is 2.3%. The market is pricing in average annual inflation of 2.3% over the next decade.

Breakeven inflation rates are closely watched because they reveal whether central banks have anchored inflation expectations. If a central bank is credible, long-term breakevens should remain close to its target even when short-term inflation spikes. If long-term breakevens start drifting upward, it suggests the market is losing confidence in the central bank’s ability or willingness to control inflation over time. That is a critical signal.

Inflation swaps

A second important instrument for measuring inflation expectations is the inflation swap.

An inflation swap is an over-the-counter derivative in which one party pays a fixed rate (the “inflation swap rate”) and the other pays realised inflation over the same period. The fixed rate is set at inception so that the swap has zero value at the start. That fixed rate therefore represents the market’s expectation of average annual inflation over the tenor of the swap.

Inflation swaps complement breakeven rates from bonds. While breakevens are derived from government bond markets and can be affected by liquidity premia, supply effects, and the specific construction of inflation-linked bonds, inflation swaps provide a cleaner, more standardised read on inflation expectations. They are available across a wide range of tenors and are actively traded in EUR, USD, and GBP.

In practice, both measures are watched together. If the 5-year EUR inflation swap rate is 2.1% and the 5-year breakeven from German linkers is 2.0%, the two measures are broadly consistent. Significant divergences between the two can signal technical dislocations or liquidity issues in one market or the other.

8.5 Purchasing Managers’ Index (PMI)

GDP tells you what happened last quarter. The Purchasing Managers’ Index (PMI) tells you what is happening right now and what businesses expect next.

PMI is a survey-based indicator. Each month, purchasing managers at hundreds of companies are asked whether key variables (new orders, output, employment, supplier delivery times, inventories) are rising, unchanged, or falling compared to the previous month. The responses are aggregated into a diffusion index scaled from 0 to 100. A reading above 50 signals expansion. A reading below 50 signals contraction. The further from 50, the stronger the signal.

PMI is published separately for manufacturing and services, and a composite index combines the two. The surveys are conducted by S&P Global for most countries and by ISM (Institute for Supply Management) for the United States.

PMI matters to markets for three reasons. First, it is timely: the “flash” (preliminary) PMI is published before the end of the month it covers, making it one of the earliest indicators of economic activity for any given period. Second, it is forward-looking by design. The new orders component, in particular, captures demand that has not yet shown up in production or GDP data. Third, it covers the services sector, which represents the majority of GDP in advanced economies and is often harder to track than manufacturing.

A sharp drop in the manufacturing PMI new orders component, for instance, can signal a growth slowdown months before it appears in GDP figures. Bond markets react because a weaker growth outlook implies a more dovish central bank, which means lower future rates and therefore higher bond prices today.

8.6 Employment data: Nonfarm Payrolls and the unemployment rate

Employment data is arguably the most market-moving release in the US calendar. Two measures dominate the discussion, and they tell different stories.

Nonfarm Payrolls

Nonfarm Payrolls (NFP) is published on the first Friday of each month by the Bureau of Labor Statistics. It reports the net change in the number of jobs added or lost in the US economy during the previous month, excluding farm workers, private household employees, and non-profit organisation employees. NFP is a flow measure. It tells you how many jobs the economy created last month, not how many people are employed in total.

NFP is considered a relatively forward-looking indicator because job creation responds quickly to changes in business confidence and demand. When companies see strong order books, they hire. When demand softens, hiring slows before layoffs begin. A surprise in NFP (stronger or weaker than the consensus forecast) can move Treasury yields, equity indices, and the dollar within seconds of the release. A strong NFP number suggests the economy is running hot, making rate cuts less likely and potentially bringing rate hikes closer. A weak number suggests the opposite.

The unemployment rate

The unemployment rate is published in the same monthly report but tells a different story. It measures the share of the labour force that is actively seeking work but has not found it. Unlike NFP, the unemployment rate is a lagging indicator. It typically peaks well after a recession has begun, because it takes time for companies to move from hiring freezes to layoffs to the point where unemployed workers show up in the survey data. Similarly, it falls slowly during recoveries as discouraged workers re-enter the labour force.

Despite being a lagging indicator, the unemployment rate matters because it is central to the Fed’s dual mandate. The Fed is required to pursue maximum employment alongside price stability. A rising unemployment rate, even if it lags the cycle, can push the Fed toward rate cuts. A persistently low unemployment rate can signal that the labour market is too tight, generating wage pressure that feeds into inflation. This is the connection between employment data and the wage-price dynamics discussed in section 8.3.

In the eurozone, the equivalent release is the monthly unemployment rate published by Eurostat. While it moves markets less dramatically than US NFP (partly because the ECB has a single mandate focused on price stability), it remains an important gauge of economic conditions and is watched closely for signs of labour market deterioration that might influence ECB rate decisions.

8.7 The release calendar: how it all fits together

These indicators are published on a fixed schedule, and the market’s reaction depends not on the number itself but on the gap between the actual release and the consensus forecast. Economists at major banks and research firms publish forecasts ahead of each release, and the market prices in the consensus before the data arrives. A CPI print of 3.2% when the market expected 3.0% is an inflationary surprise and will push yields higher. The same 3.2% print when the market expected 3.4% is a dovish surprise and will push yields lower. The absolute level matters for context, but it is the surprise relative to expectations that drives the immediate market reaction.

9. The natural rate of interest

Macroeconomists use the concept of the natural rate of interest (commonly written as $r^*$, pronounced “r-star”) to describe the interest rate at which the economy would grow in a balanced way: neither overheating nor stagnating, with inflation at target and employment roughly full.

The natural rate is not directly observable. Economists estimate it from economic models, and it changes over time. Demographics matter: an ageing population saves more and invests less, pushing down the equilibrium rate. Productivity trends matter: a long period of weak productivity growth reduces the return on investment, pulling $r^*$ down. The structural GDP growth dynamics discussed in section 6 feed directly into estimates of $r^*$.

For practitioners, the concept is useful as a reference point. If the central bank’s policy rate is well above $r^*$, monetary conditions are tight and growth is likely to slow. If the policy rate is below $r^*$, conditions are loose and inflationary pressure is likely to build.

You will frequently encounter the natural rate in central bank communications. ECB Governing Council members, Fed governors, and other central bank officials regularly refer to $r^*$ in speeches and press conferences when explaining their policy stance. While neither the ECB nor the Fed publishes an official $r^*$ estimate, central bank research departments produce model-based estimates, and the Fed’s “longer-run” dot in its interest rate projections is widely interpreted as a proxy for the nominal neutral rate. Statements like “we believe the policy rate is now in restrictive territory” or “rates are close to neutral” are implicitly referencing $r^*$. When a central bank governor says that the neutral rate has risen, it signals that the bank sees a higher floor for interest rates going forward, which has direct implications for the pricing of long-term bonds, swaps, and any hedge built on rate expectations.

10. What drives FX rates

Exchange rates are prices that connect two monetary systems. A combination of interest rate differentials, inflation differentials, growth prospects, capital flows, trade balances, and geopolitical factors determines them.

10.1 Interest rate differentials

The most direct driver of short-term FX movements is an unexpected change in the interest rate differential between two countries.

Markets are forward-looking. By the time a central bank raises or cuts rates, the move is usually priced into the exchange rate. What triggers sharp FX reactions is a surprise: a larger hike than expected, an unexpected hold, or a shift in forward guidance that changes the expected rate path. It is the gap between what the market anticipated and what actually happens that moves the spot rate.

The mechanism is capital flows. When a central bank surprises with a more hawkish stance than expected, the higher yields on offer attract capital from abroad. Asset managers reallocate portfolios toward higher-yielding bonds, banks adjust cross-border lending, and speculative investors add to carry trade positions, borrowing in the lower-yielding currency to invest in the higher-yielding one. This increased demand for the domestic currency pushes the spot rate higher. The reverse applies when a central bank surprises on the dovish side: capital flows out, carry trades are unwound, and the currency weakens.

While the initial repricing is typically rapid, a wide interest rate differential can continue to support a currency at its new level for months, as ongoing portfolio flows and carry positions sustain demand. This support tends to fade when the differential narrows, when volatility rises enough to make carry trades unattractive on a risk-adjusted basis, or when other macro forces (such as inflation or a deteriorating trade balance) begin to dominate.

10.2 Inflation differentials and purchasing power parity

Over longer time horizons, inflation differentials drive exchange rate movements through the concept of purchasing power parity (PPP). The intuition is straightforward.

Suppose avocados cost 1 peso in Mexico and 1 peso in Colombia, and the exchange rate between the Mexican peso (MXN) and the Colombian peso (COP) is 1:1. Now suppose Colombia experiences a period of strong inflation that doubles domestic prices: avocados in Colombia now cost 2 COP, while Mexican prices remain at 1 MXN. If the exchange rate stays at 1:1, a trader could convert 1 COP into 1 MXN, buy an avocado in Mexico for 1 MXN, ship it to Colombia, and sell it for 2 COP. This would be a risk-free profit. This arbitrage would continue until the exchange rate adjusts. For the opportunity to disappear, the Colombian peso must depreciate to roughly 1 MXN = 2 COP, restoring price equivalence across borders.

In practice, not all goods are tradeable across borders and transport costs create friction. PPP therefore works better as a long-run anchor than as a short-run predictor. But when one country runs significantly higher inflation than another for a sustained period, it tends to result in a weaker currency over time.

10.3 Trade balances: net importers vs. net exporters

A country’s trade balance, the difference between its exports and imports, creates structural demand and supply for its currency. A net exporter (a country that exports more than it imports) receives foreign currency in payment for its goods, which it then converts into domestic currency. This creates sustained demand for the domestic currency and tends to support its value. A net importer does the opposite: it must sell domestic currency to buy foreign currency, putting downward pressure on it.

This is why the trade balance appears in the FX drivers table and why currency policy is often politically charged. A weaker currency makes a country’s exports cheaper and more competitive abroad, benefiting domestic manufacturers and workers in export sectors. A stronger currency makes imports cheaper, benefiting consumers and companies that rely on foreign inputs, but it hurts exporters.

These trade-offs explain why currency levels are a frequent subject of political debate. Export-oriented economies, such as Germany or Japan, have historically been accused of favouring a weaker currency to boost competitiveness. The United States, as a major net importer, has periodically accused trading partners of deliberately keeping their currencies undervalued. The Trump administration made this argument explicitly, targeting China and, at times, the eurozone, framing currency weakness as an unfair trade practice. Whether driven by central bank policy, market forces, or deliberate intervention, the level of the exchange rate has real consequences for trade flows, corporate earnings, and ultimately jobs, which is why it attracts political attention.

10.4 Geopolitical events and flight to quality

FX rates are also sensitive to geopolitical risk. Events that create uncertainty (wars, sanctions, elections, sudden trade barriers) can trigger rapid reallocation of capital across currencies and countries.

Certain currencies are considered safe havens: investors flock to them in times of stress because of the depth of their markets, the stability of the issuing country, or historical convention. The US dollar is the preeminent safe-haven currency. The Swiss franc and the Japanese yen also exhibit this property.

Flight to quality occurs when uncertainty spikes and investors reduce exposure to riskier assets, converting into dollars, Swiss francs, or short-term US Treasuries regardless of the prevailing interest rate differential. This is why the dollar often strengthens during global financial crises, even when the Fed is cutting rates aggressively.

The 2022 energy shock in Europe provides a concrete example. As gas prices surged following Russia’s invasion of Ukraine, the euro weakened significantly against the dollar, partly because the eurozone’s terms of trade deteriorated sharply: Europe was importing expensive energy priced in dollars while its export revenues remained in euros.

10.5 Summary of FX drivers

11. Recent context: from zero rates to hiking cycle and back

The period from 2020 to the present illustrates each of the forces described above, often in an accelerated and unusually legible sequence.

11.1 COVID-19 and the zero-rate environment (2020 to 2021)

When COVID-19 caused a sudden collapse in economic activity in early 2020, central banks responded immediately. The Fed cut rates to near zero in March 2020. The ECB, already in negative territory, launched massive additional bond-buying programmes. Real rates plunged deeply negative. Forward guidance promised that rates would remain low for years. The goal was to support the economy through the crisis and prevent a deflationary spiral.

11.2 The inflation surge (2021 to 2022)

As economies reopened, supply chains failed to keep pace with rebounding demand. Energy prices rose, partly due to the structural underinvestment in fossil fuels during the pandemic and then sharply again after Russia invaded Ukraine in February 2022. Headline inflation reached levels not seen since the 1980s: above 10% in the eurozone and above 9% in the United States.

Initially, central banks characterised inflation as “transitory”, expecting it to fade as supply chains recovered. This assessment proved incorrect. Wage inflation began to build, especially in the US, feeding into the labour-intensive services sector where price pressures tend to be stickier and harder to reverse. Core inflation, which strips out volatile energy and food components, rose steadily. Inflation expectations started drifting upward: a sign that market confidence in central bank targets was weakening.

11.3 The hiking cycle (2022 to 2023)

Both the Fed and the ECB pivoted sharply. The Fed raised its policy rate from near zero to over 5% between March 2022 and July 2023, the fastest tightening cycle in four decades. The ECB raised its deposit rate from -0.50% to 4%, a move of 450 basis points in about 14 months.

Real rates moved from deeply negative to positive across major economies for the first time in many years. Long-term yields followed: the 10-year US Treasury yield, below 1% in 2020, reached above 5% in late 2023. European government bond yields, which had been negative in Germany as recently as 2021, rose sharply.

11.4 ECB vs. Fed divergence: a worked example

The post-hike period illustrates how central bank divergence affects FX markets. By late 2023 and into 2024, US inflation proved stickier than in Europe, partly because US wage growth remained robust and the labour market tight. The ECB, facing weaker growth and faster-falling core inflation in the eurozone (although services inflation remained sticky), began cutting rates in June 2024. The Fed held rates higher for longer.

This policy divergence widened the interest rate differential between USD and EUR. Capital seeking higher safe returns flowed toward dollar assets. The dollar strengthened against the euro, approaching parity (1 USD = 1 EUR) at points in late 2024 and early 2025. For European companies with USD revenues or USD-denominated costs, this movement in the exchange rate had direct bottom-line consequences. For treasury practitioners, understanding why the differential moved and where each central bank was likely to go next was essential to making hedging decisions.

11.5 The geopolitical overlay

Running through this entire period was a set of geopolitical developments that repeatedly influenced rate expectations and FX markets: the energy price shock from the Ukraine war, the resurgence of trade tensions between the US and China, and the wave of tariff announcements in 2025. Each of these fed directly into inflation forecasts, and therefore into central bank policy expectations, and therefore into bond yields and exchange rates.

This is not incidental. For a corporate treasury team hedging FX or interest rate exposure, a geopolitical event is not background noise. It is a direct input into the macro environment that drives the cost and shape of every hedge.

12. Key takeaways

• Interest rates exist because of three forces discussed in the chapter Time value of money & discount factors: opportunity cost, inflation erosion, and uncertainty. This chapter examines the macroeconomic environment that determines how these forces evolve over time.
• The Fisher equation links real and nominal rates: real rate ≈ nominal rate minus expected inflation. Economic decisions respond to real rates, not nominal ones, which is why this distinction is central to macroeconomics.
• Negative real rates are not a recent phenomenon. Bruegel documented that real government bond yields had fallen below zero in every euro area country by September 2019, well before the COVID-19 inflation surge.
• Real rates can be measured using inflation-linked bonds (TIPS in the US, OATi in France). The gap between a nominal and an inflation-linked bond yield is the breakeven inflation rate. Inflation swaps provide a complementary, often cleaner, market-based measure of inflation expectations.
• The ECB has a single mandate (price stability, 2% symmetric target), the Fed has a dual mandate (price stability plus maximum employment), and the BoE sits in between. These different mandates produce different policy reactions to the same economic data.
• Central banks influence rates through three main tools: the policy rate, open market operations, and quantitative easing. They also use forward guidance to shift expectations about the future path of rates.
• Monetary policy works with long lags because prices are sticky. A rate hike today typically takes 12 to 18 months to fully reduce inflation.
• GDP measures total economic output. Real GDP strips out price changes and captures actual growth. Long-term rates reflect the market’s joint forecast of future real growth and inflation, not just today’s central bank rate.
• Stagflation, the combination of stagnant growth and high inflation, is almost always caused by supply shocks (notably oil). The 1970s episode demonstrated that tolerating inflation to protect growth makes both problems worse. Modern risks from Middle East conflicts and energy disruptions keep this scenario relevant.
• The distinction between backward-looking indicators (GDP, CPI, unemployment rate) and forward-looking indicators (PMI, Nonfarm Payrolls, PPI as a leading signal for CPI) determines which data releases move markets and which merely confirm what is already known.
• CPI measures prices paid by consumers. PPI measures prices received by producers. PCE is the broader, substitution-adjusted measure that the Fed officially targets. Central banks focus on core measures (excluding food and energy) because they give a cleaner read on persistent inflation. Wage inflation is a particular concern because it is sticky and can make inflation self-sustaining through a wage-price spiral.
• PPI leads CPI by several months. During the 2021-2023 eurozone inflation episode, PPI peaked in August 2022, headline CPI peaked in October 2022, and core CPI peaked only in March 2023. PPI is also far more volatile than CPI, which is itself more volatile than core CPI.
• PMI is the most timely growth indicator, published before the month it covers has ended. Nonfarm Payrolls is the most market-moving US data release. The unemployment rate is a lagging indicator but matters because it is central to the Fed’s dual mandate.
• Markets react to the surprise relative to consensus, not to the absolute number. A CPI print of 3.2% is hawkish if the market expected 3.0% and dovish if the market expected 3.4%.
• The natural rate of interest ($r^*$) is the equilibrium rate consistent with stable growth and on-target inflation. It is not observable but is frequently referenced by central bank officials when explaining their policy stance.
• FX rates are driven by interest rate differentials in the short run, inflation differentials and trade balances in the long run, overlaid with geopolitical events and flight-to-quality flows. Currency levels are politically sensitive because they directly affect exporters, importers, and jobs.
• The post-COVID cycle, from zero rates through the inflation surge to the fastest hiking cycle in decades, illustrates every one of these dynamics in a compressed and highly relevant time frame.