Like the drummer in a band, central banks sit at the heart of modern economies. Read any financial news article and you’re likely to come across references to these arcane institutions: the Federal Reserve in the US, the Bank of England, or the European Central Bank (ECB). They play a key part in maintaining economic health – it’s their job to maintain the rhythm.
What do they actually do? For one, they’re in charge of printing money – though nowadays this is an electronic process. They oversee commercial banks (like HSBC or Chase – the ones you or I are used to dealing with on a daily basis), lending money to them and setting rules that prevent them from doing anything too risky. If a person or a company takes out a loan from a commercial bank, shiny new electronic money is deposited in their account. This is how money is created and flows into an economy!
By managing a country’s interest rates central banks aim to keep the economy stable: keeping unemployment and inflation low, while maintaining steady economic growth. The interest rate set by a central bank will dictate the return investors receive without taking any risk of losses. All other investments have to compete with this “risk-free rate”, so if it moves the prices of all other assets will be affected.
Anything else? Since the financial crisis of 2008, plenty of central banks have also been tasked with monitoring the financial health of their nation’s commercial banks. Some will periodically “stress test” banks by estimating their chance of collapse should the economy slow dramatically or house prices plummet. Many also set rules to keep important but boring things like electronic payment systems working smoothly.
Some countries try to manage their currency’s exchange rate, keeping it at a certain price – usually against the US dollar. The central banks in these economies are responsible for maintaining this exchange rate, by buying and selling currencies in huge quantities (we’ll cover this in more detail in session three).
Why do I need to know any of this? Understanding central banks and their roles will make reading the financial press that bit easier, which is always a plus. But more importantly, the decisions central banks make will massively affect your investments. By understanding what they’re able to do and the impact their policies may have, you’ll have a much better understanding of the way markets move.
That’s enough drumming for now. We’ll kick things off by tackling central banks’ biggest function: setting interest rates.
Central banks don’t directly set the interest you’ll receive on your savings (and pay on your borrowings). Instead they set an underlying interest rate, like John Bonham laying down a beat, and commercial banks riff over the top. (Yes, in this analogy Jimmy Page is a commercial bank. Sorry, Jimmy).
This central bank either sets the amount that commercial banks are charged to borrow from each other (as in the US, where the Fed sets the “federal funds rate”), or the amount banks are charged to borrow from the central bank (like in the UK, where the Bank of England sets the “base rate”).
How does this feed through to me? Commercial banks look at these rates and then set interest rates for their own products accordingly: normally charging a bit more than the base rate for lending, and paying savers a bit less. (This gap is one way banks make money). When the central bank adjusts the base rate, banks will usually adjust their rates too – though there’s unsurprisingly a tendency to not pass on all the benefits to the consumer…
Central banks tend to make these decisions a few times a year: for example, the US Fed’s Open Market Committee meets eight times a year, and decides at each meeting whether to raise, lower or maintain the base rate.
Why does the central bank change the interest rate? Because low interest rates reduce the cost of borrowing, they help to stimulate the economy by making it easier for people to spend – potentially allowing for increased business activity and reduced unemployment.
But if growth is too fast, inflation might rise – making everything more expensive for everyone, including companies who may then need to cut costs and downsize. In that scenario, a central bank might raise interest rates to try and temper growth. The job of a central bank is to achieve a happy medium: economic growth, low unemployment, and relatively low inflation. Governments often instruct central banks to aim for a certain inflation level – in the UK, for example, the target is 2%.
In financial jargon, when the central bank is cutting interest rates we say they’re “loosening monetary policy”, and when interest rates are rising the bank is “tightening monetary policy.”
What does all this mean for me? The decisions of major central banks will ripple through almost every market and economy in the world. If they raise rates, it will increase the attractiveness of keeping cash in a bank. The value of any bonds you hold is likely to fall, as their fixed coupon payments suddenly look less attractive, relatively. The relationship between interest rates and stock prices is more complicated. It generally depends on why the central bank is increasing rates – for example, is the decision driven by a strengthening economy (good!) or spiraling inflation (bad!)? But stocks will often do well when interest rates are low (on the assumption that the lower rates will feed economic growth).
Next up: how a central bank can ruin your holiday.
In the not-too-distant past, currencies were linked to a certain measure of gold: $35 would buy you one ounce of gold, for example. This caused some problems for economies – it meant they couldn’t just increase the money supply on a whim (some blame this gold standard for why the Great Depression was so… great).
When did this change? From the 1970s most economies moved to a “floating” currency regime: where currency values aren’t tied to anything in particular, and are instead determined by the market. But this has its downsides too: for example when the dollar spikes in value, US exports may decline (because other countries have to pay more for them), which could hurt the US economy.
Because of that, some countries maintain a “fixed” exchange rate: making sure that their currency value always tracks another (normally the dollar). Fixed exchange rates can be really useful for developing economies, because they make things like demand for exports much more stable. But they come with the same caveat as the gold standard, in that they limit a central bank’s control over monetary policy.
Who uses fixed exchange rates? These days, an exchange rate is rarely fixed: it’s more likely to be continually managed, but allowed to fluctuate a little bit. The biggest example of a managed exchange rate regime is China: the People’s Bank of China (the central bank) tries to “peg” the yuan to the dollar.
How are exchange rates managed? Central banks that want to meddle with exchange rates have to keep huge currency stores on hand. They then buy and sell currencies as needed: for example, if China wanted to devalue the yuan, it’d buy up dollars – reducing the global supply of the dollar, and thus driving up the dollar’s value compared with the yuan. If the yuan needs to go up in value, they’d use those dollars to buy back a bunch of yuan. This is all happening at an incomprehensibly huge scale: in October 2016, China was estimated to have $3 trillion in foreign currencies in its reserves.
Next, we’ll look at another key role for central banks: how they can help in a crisis.
When times are tough, central banks come to the rescue. Their policy tools give them immense power over the economy, meaning they can help get things back on track. When a recession hits, the first action is usually to cut interest rates – as we discussed in session two. That helps to stimulate the economy by making it cheaper for companies and individuals to borrow. The bank will also issue messages to try to calm markets: for example, after 9/11 the Fed was very clear that it would keep cash flowing.
Are there other tools they can use in a recession? Yep, and they’re big ones. In the past decade you might have heard of “quantitative easing”: this is when the central bank prints more money and injects it into the economy (normally through buying government bonds). This increase in the money supply helps to stimulate the economy. Once interest rates are basically at zero (as they were for several years following the 2008 financial crisis), quantitative easing is one of the only ways to help jumpstart a recovery.
There’s one other thing that central banks can do: act as a lender of last resort. In a crisis, there can be “bank runs,” where people will go to ATMs and withdraw all their funds. Because most of your bank savings aren’t actually kept in cash, if everyone goes at once the bank will soon run out of money altogether – and collapse. To stop that from happening the central bank can loan money to commercial banks, keeping them liquid. This happened in 2008, when banks across the world were bailed out by central banks.
Can central banks prevent a recession? Not really: there are too many factors at play for any institution to have total control. But through careful management of interest rates they can try to avoid one, and they can also set rules to prevent recessions from becoming too bad. The most important of these is the minimum reserve requirement. As we discussed above, banks only keep a fraction of your account in cash, but the central bank can make them increase this proportion to de-risk the economy.
Finally, we’ll look at why you hear so much about central banks…
Central bankers are the Kardashians of the finance world: professional traders are obsessed with every single thing they say and do. Every comment a central banker makes is scrutinized like tea leaves, with everyone desperately trying to predict what the bank’s future decisions will be. A slight hint that the Fed might be considering an interest rate hike sometime in the future is enough to move markets. Central banks’ statements about an economy’s health carry a lot of weight too: if they seem optimistic about the future, markets will respond well.
Who writes these statements? The Fed, Bank of England, and European Central Bank are all nominally independent institutions – they can’t be influenced by the government (though politicians may get to decide who’s put in charge). This is intended to stop politicians from meddling with monetary policy to win elections, and it mostly seems to work. That said, the relationship is complex – the US president’s angry tweets probably have some effect on the Fed’s thinking, for example.
This independence isn’t true in all countries either: the People’s Bank of China is decidedly not free from Communist Party meddling (though it’s starting to gain a little more liberty). That’s an effect of the general Chinese political system though, rather than any economic reasons. And even the illustrious Bank of England was only granted independence from the UK government in 1997.
It’s worth noting that although some of the functions of central banks are the same globally, there’s a huge amount of geographic diversity in the way they operate. The Fed and the Bank of England have very different methods of managing interest rates, the European Central Bank has to manage a currency area across 19 countries, and in China the bank has to operate in a much stricter political environment.
Central banks can be opaque and arcane institutions, but they’re behind absolutely everything in the economy: from bank loans to the price of your groceries, their decisions reach everywhere. So next time you look at your banknotes, or check the balance in your account, remember all that’s going on behind the scenes…
That’s it for this pack. Hopefully next time someone mentions the Fed or the ECB you’ll have more of an idea what they’re going on about – and why you should care!