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 keep up the rhythm.
"I’m passionate about the need for us to do more to explain economic and financial topics in language everyone can understand. So I’m delighted the Bank is partnering with Finimize on this new pack on the role of central banks. Understanding how decisions taken by institutions such as the Bank of England affect us all is really important. That’s the case whether you’re a seasoned investor, are learning about the world of finance for the first time, or just want to make better everyday financial decisions."
- Andy Haldane, Chief Economist, Bank of England
What do central banks actually do? 🤷
For one, they’re in charge of printing money.
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.
They oversee commercial banks (like HSBC or Chase – the ones normal people deal 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!
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 (more on that to come later).
Why should I care? 🤔
Understanding central banks and their roles will make reading financial news easier, which is always a plus. But more importantly, the decisions central banks make massively affect your investments. By being aware of what central banks are able to do and the impact their policies may have, you’ll have a much better understanding of the way markets move.
Central banks and interest rates 📈
Why do central banks tinker with 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.)
An economy’s central bank either sets the “base rate”: either 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 else the amount banks are charged to borrow from the central bank (like in the UK, where the Bank of England sets the “Bank Rate”).
How does this impact 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 than that. (This gap, called the “net interest margin”, is how banks make money on traditional savings-and-loans business.) 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 mean a low cost of borrowing, they help to stimulate the economy by making it cheaper for people to spend on credit – potentially leading to increased business activity and reduced unemployment.
But if growth is too fast, inflation might become too high and unstable – making it difficult for households and businesses to plan for the future, because prices are hard to predict with confidence. This can hinder spending and slow growth. In that scenario, a central bank might raise interest rates to try and temper the rate of growth in spending, and bring inflation back under control.
In financial jargon, when a central bank is cutting interest rates it's said to be “loosening monetary policy”, and when interest rates are rising the bank is “tightening monetary policy”.
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.
All (currency) change 💰
Different kinds of currency regimes – and how they work
In the not-too-distant past, under the “gold standard”, 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 the gold standard for why the Great Depression was so… great).
When did this change?
Beginning in 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's value always tracks another (normally the US 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 to the yuan.
If it wants the yuan to go up in value, China will use those dollars to buy back a bunch of yuan. This is all taking place on an incomprehensibly large scale: in October 2016, China was estimated to have $3 trillion in foreign currencies in its reserves.
Don’t panic! ⚠️
How can central banks help in a recession?
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 earlier. 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.
What other tools can central banks use in a recession? ⚒️
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. When interest rates are already sitting close to 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 flock to ATMs and withdraw all their funds. Because most of your commercial 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 one institution to have total control. But through careful management of interest rates central banks 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.
Through the grapevine 🍇
Why every Fed comment is scrutinized
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 independent institutions – their policies can’t be influenced directly by the government (though politicians may get to decide who’s put in charge). This is supposed 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 diversity in the way individual institutions 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.
Knowledge in the bank 😉
Central banks can be opaque and arcane institutions, but they’re behind much of what goes on 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 guide ✅ 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!
Want to know more? Check out the Bank of England’s Knowledge Bank for a user-friendly guide to the world of central banking.