What is a central bank?

Banks are one of the cornerstones of our society. They have been around for centuries and play a pivotal role as intermediaries between creditors and debtors. Whether we want to borrow to purchase a house, deposit savings, pay bills, receive wages or set up a business, we need a bank to assist. Banks provide a host of services, which include:

• Savings accounts
• Mortgages
• Credit cards
• Investment strategies
• Foreign currency exchange

It is important to note that the banks serving retail and business customers are known as commercial banks. Central banks work differently.

Central bank explained

Central banks are part of state administration. They were set up to be the “lender of last resort” for the financial sector, to control the flow of money and credit to a nation’s economy. They often play the role of a financial sector regulator, ensuring that this bloodstream of the economy runs smoothly and that commercial banks operate within the rules and regulations preventing excessive risk taking.  

They also offer services that measure a country’s economic performance, especially related to hard currency reserves, international trade and balance of a nation’s accounts with its foreign trading partners and investors. In addition, they provide forecasts and research about the economy. The world’s most influential central banks include:

• Federal Reserve (USA)
• European Central Bank (Eurozone)
• Bank of England 
• People’s Bank of China
• Bank of Japan

Central bank's goals and duties 

One of key goals of central banks is to issue and control the stability of a country’s currency. Currencies of countries with biggest economies are often seen as “reserve” currencies and are widely traded on international foreign exchange markets. The leading reserve currency is the US dollar, followed by the euro, Japanese Yen and the British pound sterling. Chinese Yuan has so far failed to become a reserve currency because of restrictions on its trade. Controlling the stability of currency runs parallel with another key goal of the central bank – maintaining low levels of inflation. The primary tool the central bank uses to ensure currency and price stability is the interest rate it sets for commercial banks and the entire economy. The power of the central bank to set the level of interest rates and control money supply to the economy makes it a central player in executing a country’s economic policy. Initially set up as part of government, central banks have seen their independence increase during the 20th century to ensure they would be free of short-term political pressure. Many have collegial bodies which decide on the best course of monetary policy by vote. 

Central bank and economy 

An effective and trusted central bank is one of the key factors for any country hoping to obtain sustainable growth and investment. They can operate in the limelight -- communicating its policy changes to the market, but can also act quietly in the background when required. They can intervene in the foreign exchange markets by selling or buying national currency when it deviates from what the bank considers its fundamental value against other currencies. Currency interventions are used rarely because leading central banks prefer currency levels to be set by market forces in line with shifts in relative strength of key economies. In times of a crisis, a central bank will intervene to stabilise the economy and prevent panic on the financial markets. 

Monetary policy and interest rate 

To ensure stability and predictability for economic actors and investors, central banks will very often have an official “mandate” to keep the inflation rate close to a certain level, usually around two or three percent. Under this “inflation targeting” system, a central bank will react to inflation diverging from this target by raising interest rates when inflation accelerates and lower them when it falls close or below its target. The main purpose of this is to either limit or expand availability of credit to the economy, thus preventing a cycle of boom and bust. It is an incredibly difficult balancing act where a number of variables must be considered before central banks decide to alter the level of interest rates. If interest rates are set too high, it may reduce inflation but also push the economy into recession. If they are too low while inflationary pressures are building in the economy, economic activity can “overheat” causing imbalances and accelerated inflation, which then becomes hard to beat back. Movements in a country’s currency will also reflect whether the market considers the level of interest rates as appropriate versus the broad economic performance. If markets perceive the central bank’s credibility in fighting inflation as weak, they may opt to sell that country’s currency, creating a vicious cycle for the economy. If the bank’s reputation is high, investors have confidence the bank will not shy away from higher interest rates to fight inflation and will buy such currency. Trading on differences in interest rates of different currencies is called arbitrage or carry trade and central banks will monitor it as another factor in their decision-making.  

If central banks fail to guard the value of the nation’s currency by for example printing too much of it to cover the country’s budget deficit, the likely result is a loss of value for such currency and high inflation as imported goods become more expensive and economic actors as well as citizens lose confidence. Such “currency crises” and hyperinflation have plagued many emerging markets, including Argentina, Venezuela or Zimbabwe.  

Modern central banks tools - QE and QT

QE 

Quantitative easing (QE) is a relatively new tool a central bank can deploy when the economy stagnates despite low inflation and low interest rates. With interest rates close to zero, the central bank can try to stimulate the economy by providing liquidity and increasing money supply by buying assets from the financial sector at preferential rates. 

 The two highest-profile examples of QE in action were the 2008 financial crisis and the 2020 COVID pandemic. Led by the Federal Reserve, global central banks pumped trillions of dollars into the economy to prevent a sharp contraction and to save the financial sector from collapse. The key risk of QE is that the huge increase of money supply at low interest rates will sooner or later spur inflation. Choosing the right amount of quantitative easing and timing its end is a key challenge for the central banks. 

QT

Quantitative Tightening is the opposite of quantitative easing. Any financial instruments the central banks have purchased, like government bonds, are allowed to mature instead of being reinvested by fresh purchases. This limits the money supply. QT is not as effective as QE because it takes time to filter down to the market interest rates and may not be enough to stop inflation when economic momentum is regained. The bout of record high inflation which took the world by surprise following the end of the pandemic last year forced central banks to sharply raise interest rates. 

Central banks and markets 

Any decisions made by any central bank have knock-on effects on financial markets, especially during a crisis or a surprising development such as the pandemic or the current trouble with inflation. The stock market, commodities and currency exchange markets are all sensitive to changes in interest rates. Investors will often adopt different strategies based on their expectations of a central bank’s next moves, for example selling stocks when they expect interest rates to go up to combat inflation. If you are looking to invest at times of market volatility, mobile trading apps such as amana can execute trades for you. Always remember to invest with caution and that your capital is always at risk.