What Is A Central Bank?
A central bank manages a nation's currency, money supply and interest rates and acts as a lender of last resort to the country's banks. Many are also responsible for regulating and supervising their country's banks. Many are set up to be independent from their government, although their directors are usually appointed by that country's chief executive or leader of government.
Most countries have their own central bank, but the following eight have influence beyond their borders:
- U.S. Federal Reserve
- European Central Bank
- Bank of England
- Bank of Japan
- Bank of China
- Swiss National Bank
- Bank of Canada
- Reserve Bank of Australia
- Reserve Bank of New Zealand
The Swedish Central Bank, Sveriges Riksbank, says it is the oldest central bank in the world, with operations beginning in 1668.
The Bank of England was founded shortly after that, in 1694, as a private bank to act as banker to the government. It was nationalised in 1946 and then was granted independence from the government in 1997. It is responsible for setting monetary policy and interest rates, maintaining financial stability, and regulating the country's banks and insurance companies.
The goal of central banks is to ensure economic and financial stability, which usually means low inflation, low to moderate interest rates, high levels of employment and sustainable economic growth. They do this through monetary policy, which they try to achieve through public pronouncements of their intentions plus open market operations to manage the money supply and the level of interest rates.
The main mechanism available to central banks for implementing monetary policy is by influencing the level of interest rates and the amount of money banks have available to lend.
An accommodative monetary policy means the central bank wants low interest rates and more money available in the economy to encourage economic activity. However, if the central bank determines that the economy is growing too fast and may ignite inflation, it tightens monetary policy by raising interest rates and restricting the amount of money available in the financial system.
In the U.S., for example, the fed's monetary policymaking unit is the Federal Open Market Committee (FOMC). It sets the federal funds rate, which is the interest rate that banks pay to borrow and lend money to each other overnight that they hold on deposit at the Fed. This rate influences to a great deal the general level of all interest rates throughout the economy, both short- and long-term.
Open Market Operations
In addition to setting key interest rates, central banks have other tools they use to keep interest rates within the desired range.
Through open market operations, they buy and sell securities with banks and other financial institutions. By selling securities, they drain money from the financial system, reducing the amount available for lending and therefore putting upward pressure on interest rates. Buying securities has the opposite effect, making more money available for banks to lend and therefore lowering rates.
Central banks also dictate the amount of money commercial banks must keep on deposit in cash. By lowering these requirements, banks have more money to make loans, while raising them has the contrary effect.
The Money Supply
Central banks also have some level of control over the money supply, which is the amount of money circulating in the economy. This can also affect interest rates. A plentiful supply of money generally means low rates, while less money available makes borrowing more expensive and therefore discourages business activity. The central bank can increase or reduce the size of the money supply by buying and selling securities.
Since the late 1980s, however, many central banks in the developed world have moved away from trying to manipulate the size of the money supply and instead focus on trying to target an optimum level of inflation, usually about 2% a year. According to the International Monetary Fund, which provides policy advice and technical assistance to countries, many low-income nations are also transitioning away from trying to target the size of the money supply in favour of targeting inflation.
In the wake of the global financial crisis in 2008, many central banks eased monetary policy by cutting short-term interest rates to zero. In some cases, they took the unprecedented step of lowering rates below zero, as in the case of the European Central Bank, the Swiss National Bank and others.
When that failed to achieve the desired result of raising inflation and boosting economic growth, many of them undertook "unconventional monetary policies" including quantitative easing. This policy consists of buying long-term bonds, both issued by the government and from private corporations, in order to try to lower long-term rates and to encourage investors to take on more risk by buying stocks instead of bonds.
A central bank manages a nation's currency, money supply and interest rates and serves as a lender of last resort to the country's banks. Many of them also regulate the banks in the country. Central banks try to achieve their goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates, through their monetary policy. They conduct the policy through a combination of raising and lowering interest rates, and open market operations, buying and selling securities to increase or decrease the amount of money available for lending.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…