Quick Summary: A central bank or monetary authority is a monopolised and often nationalised institution given privileged control over the production and distribution of money and credit. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.
Central banks play a pivotal role in today’s global economy: They ensure price stability, economic growth, set interest rates, and promote the stability of a country’s financial sector.
Here, we’ll take a closer look at what central banks are and why they’re so important to follow for traders and investors.
Central Banks Explained
Central banks are financial institutions that control the supply and distribution of money in their domestic countries. Some central banks, such as the European Central Bank, is responsible for a group of countries that form the Eurozone instead of one single country. In the developed economies, central banks are responsible for the monetary policy through which they aim to achieve stable inflation and economic prosperity.
Most central banks are not government agencies and are politically independent. This ensures that the central bank’s focus stays on economic and monetary policies without political interference that could cause confusion in the markets.
It’s important to note that until 1971, when the world currencies were pegged to gold, the main role of central banks was to maintain the convertibility of gold into currency. As a result, inflation remained stable and governments weren’t able to increase the money supply simply by printing new banknotes.
The key difference between a central bank and a commercial bank is that central banks are given authority to issue money and control the circulation of money in an economy. Central banks also set the base rate, which is the rate charged to commercial banks for borrowing funds from the central bank. The base rate has high importance and is closely watched by investors and traders as most other interest rates are based on the base rate.
Brief History of Central Banks
The Bank of England and the Swedish Riksbank considered one of the first central banks in the world that acknowledged the role of a lender of last resort, back in the 17th century. Other early central banks include the Bank of France and the German Reichsbank. However, the main role of the latter two was mainly to finance the high military expenses of their countries.
As military expenses grew, especially in times of war, governments ordered the central bank to print more money which ultimately led to high inflation rates and economic recessions. This also proves the importance that central banks remain politically independent.
In the United States, the National Banking Act of 1863 created a single US currency and a network of national banks, but it wasn’t until 1907 that the US Congress established the Federal Reserve System. The Fed also helped finance World War I and World War II through the issuance of US debt securities.
The Fed regulates the monetary and banking system in the United States. The central government agency is located in Washington, D.C., with 12 additional regional Federal Reserve Banks located in major US cities. The actual money supply is managed by the Federal Open Market Committee, which acts as the monetary policy-making body of the Fed.
Main Roles of Central Banks
The main role of a central bank is to control the supply of money and credit in an economy. They do this by issuing banknotes and coins and setting interest rates on loans to commercial banks. This interest rate is called the base rate, which is the rate charged to commercial banks on funds borrowed from the central bank in order to meet their minimum reserve requirements.
Although banks prefer to loan from each other at the overnight rate, which is slightly lower than the base rate, in some cases the central bank will act as the lender of last resort if the interbank market is maxed out.
Central banks hike interest rates to limit and discourage people and businesses from taking loans and to encourage saving. This in turn prevents the economy from overheating and inflation pressures from spinning out of control. On the contrary, when economic growth is slowing down, central banks may decide to lower interest rates in order to stimulate spending and borrowing, which has a positive impact on the economy. However, in that case, people will get a lower return on their savings.
Major Central Banks
Here, we’ll take a closer look at the most important central banks in the world and how they’re able to move financial markets with the monetary policies.
The Federal Reserve, also called the Fed, is the central bank of the United States and probably the most influential central bank of all. The US dollar accounts for the majority of transactions on the currency market, making the Fed and its policy changes an important factor that drives exchange rates.
- The Federal Open Market Committee
The body of the Fed that sets interest rates – consists of seven Federal Reserve Board governors and five presidents of the 12 regional Fed banks. The mandate of the Fed is long-term price stability, economic growth, and low unemployment.
The Bank of England is the central bank of the United Kingdom and one of the first central banks that came into existence. The Bank of England consists of nine members who form the monetary policy committee: A governor, two deputy governors, two executive directors, and four independent experts.
The central bank of the Eurozone is the European Central Bank, consisting of the executive board with six members, and governors of all central banks from the euro-area countries. The ECB targets an inflation rate of below 2% and sustainable economic growth. The bank has also an interest in keeping the value of the euro low in order to support the European export-oriented economy.
The monetary policy committee of the Bank of Japan consists of the Bank’s governor, two deputy governors, and six other members. The central bank’s mandate is to maintain price stability and promote the stability of the financial system. Just like with the case of the ECB, one of the BoJ’s top interests is to keep the value of the Japanese yen low and to support the country’s strong export-oriented economy.
The Bank of Canada is the central bank of Canada, responsible for the country’s monetary policy and financial stability. The policy-making body consists of the bank’s governor, the senior deputy governor, and four deputy governors. The main goal of the Bank of Canada is to keep inflation stable with a target of 1-3%.
The Reserve Bank of Australia is responsible to ensure the stability of the Australian dollar, maintain full employment, and promote economic growth.The bank’s inflation target is 2-3% per year, and the monetary policy committee consists of the governor, the deputy governor, the secretary of the treasurer, and six outside experts.
The Reserve Bank of New Zealand’s main responsibility is to maintain the stability of prices, exchange rates, and interest rates. The country’s inflation target is set at 1.5%, and the ultimate decision-making power resides with the bank’s governor.
The Swiss National Bank is the central bank of Switzerland – an export-oriented country that doesn’t want to see a strong currency. That’s why the SNB generally avoids hiking interest rates if not necessary. The bank’s decision-making body consists of three members who meet quarterly to adjust the current monetary policy.
Central banks are institutions that control the supply, distribution, and circulation of money in an economy. They also set the base interest rate that is used for loans to commercial banks and act as a lender of last resort to ensure the stability of the financial sector.
The main role of most central banks is to keep inflation low and stable through regular adjustments to their monetary policies, to promote economic growth, low unemployment, and – in certain cases – control the exchange rate of the domestic currency.
Given the importance of central banks and their monetary policy decisions, investors and traders closely follow each central bank meeting to get clues about the future direction of interest rates. Unexpected rate hikes or cuts often have a significant impact not only on currency markets but on equities and debt markets as well.