LeoGlossary: Central Bank

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LeoFinance
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An independent authority over monetary policy. They also regulate the banking system, provide financial services, and conduct research.

The Central Bank has control over the monetary base along with the setting of interest rates the banks charge each other. It is a legalized monopoly in that is can issue bank notes and cash.

Although they appear to be part of the government, they are not. Central banks are owned by their member banks who are governed by a board. Therefore, they are theoretically politically independent.

Often the central bank is considered "the lender of last resort" since it is responsible for the troubled banks. It is also known to bail out governments.

Activities of a Central Bank

Functions of a central bank usually include:

  • Monetary Policy
  • Financial stability
  • Reserve Management
  • Banking Supervision
  • Payment System
  • Banknote Issuance

Other functions include:

  • economic research
  • statistical collection
  • supervision of deposit guarantee schemes
  • advice to government in financial policy

Goals of the Central Bank

  • Price Stability
  • High Employment
  • Economic Growth

Monetary Policy Tools

The central bank has a number of tools at its disposal. They are as follows:

  • open market operations (including repurchase agreements)
  • reserve requirements
  • interest rate policy (through control of the discount rate)
  • control of monetary base

Affect the Monetary Base

The central bank is able to affect the monetary base. It can do this through the creation of liabilities on its balance sheet. This is not legal tender but, rather, financial instruments that are part of the monetary base. The reserves can be placed on the balance sheets of depository institutions, thus expanding the monetary base.

Central banks often opt for this path when the economy is suffering. This is part of quantitative easing policy.

Open Market Operations

The primary means central banks use to implement monetary policy.

An activity were liquidity is given or removed through a bank or group of banks via the central bank money. The central bank buys (sells) government bonds along with other securities in the open market. Repo or secured lending with a commercial bank is the preferred solution these days. A deposit is placed with the bank for a defined period and in return takes an asset as collateral.

In addition to providing banks with liquidity (or removing it), the central bank looks to affect the monetary base through the use of its money creation powers. Through this, it seeks to indirectly affect the money supply, i.e. commercial bank money.

Interest Rates

The central bank sets the interest rate that the banks use to lend to each other. Depending upon the country, these will go by different names. In the United States, with the Federal Reserve, it is called the Fed Funds Rate.

A central bank tries to use interest rates as a means for controlling the economy. When there is an economic downturn, the goal is to get the commercial banks lending. This stands a greater chance, so the belief goes, if interest rates are lower. Essentially, this means that money gets cheaper to acquire.

Along the same lines, the opposite is also true. Central banks will use interest rates to slow down a "hot" economy. If things are becoming overheated, raising interest rates is seen as a way of diminishing demand. Under this scenario, the cost of money becomes more expensive, deterring the taking out of loans.

This is how the central bank can theoretically control the money supply. Without direct access, it has to manipulate banks into lending. The challenge is the central bank cannot force the banks to lend (or not lend). They operate as they see fit in this regard.

Reserve Requirements

Another tool the central bank can use is to tinker with the reserve requirements. This is the amount of money, either in vault cash or deposits with the central bank, a commercial bank has to keep on hand to cover demands for payment. It is designed to prevent bank runs.

The central bank can either raise or lower the reserve requirements, thus altering the potential lending patterns of the commercial banks. Again, this is an indirect action since, even if they lower the reserve requirements, there is no guarantee the banks will make loans.

Management of Sentiment

Since the central bank is limited in what is directly controls, it has to engage the market to do much of the heavy lifting. For this reason, central banks will utilize a number of tactics to try and achieve this end.

Two of these are signaling and forward guidance. Both are essentially the same although there are some nuances.

Forward guidance is where the central bank shares its projections. This could be where it sees GDP or inflation going over the next 2 years. By doing this, it lets the markets know what it feels about certain economic metrics. The market can often pick up on this and start acting in a manner befitting of that end. Hence, if it works, it becomes a self-fulfilling prophecy.

Signaling is the central bank basically foreshadowing what it is going to do. The goal here is to close the gap between the desired outcome and how things are now. For example, with interest rates, the central bank can only affect the rates bank lend to each other. However, by signaling they are going to raise interest rate, markets jump on board and start raising the different bond as well as mortgage rates. Here we see how the gap between the existing rates and desired is closed by the market.

Independence

The central bank is designed to be independent from the government. This is to ensure that the political establishment does not control monetary policy. Since fiscal policy is under their domain, most countries feel the separation of the two is beneficial.

Unfortunately, the line often was blurred throughout history. There were times when the central bank's independence was hindered. Many asset that, in most countries, there is not much difference between the two.

Nevertheless, the ideal is there. For the most part, decisions about open market operations and other activities are separate from the government. This does not mean there is not enormous influence placed upon the different central bank members.

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