Monetary Policy of Central Banks
A central bank, reserve bank or monetary authority, is an entity responsible for the monetary policy of its country or of a group of member states. The most powerful and known central banks in the world include the European Central Bank (ECB) in the European Union or the Federal Reserve System (the Fed) in the United States of America. Its primary responsibility is to maintain inflation and unemployment at a level that causes the economu to grow. Central banks also keep the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). A central bank is usually headed by a governor, but the titles are president, chief executive and managing director respectively for the European Central Bank the Hong Kong Monetary Authority and the Monetary Authority of Singapore. In most countries the central bank is state owned and has a minimal degree of autonomy, which allows for the possibility of government intervening in monetary policy. An "independent central bank" is one which operates under rules designed to prevent political interference; examples include the US Federal Reserve, the Bank of England (since 1997), the Bank of Canada, the Reserve Bank of Australia, the Banco de la Rep?blica de Colombia and the European Central Bank.
As mentioned above, the most important function is setting monetary policy. To achieve economic growth and prosperity, central banks use the following monetary policy tools.
1. Interest Rates - By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from a limited number of banks, or by purchasing and selling bonds. It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "Central bank rate." In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced. There are a couple of interest rates that central banks set:
a. Marginal Lending Rate - A fixed rate for institutions to borrow money from the CB.(In the US this is called the Discount rate). In the US the marginal lending rate is at 5.75. While in the Euro zone at 5.0%.
b. Main Refinancing Rate - This is the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans. (In the US this is called the Federal funds rate and it is at 5.25%). In the Euro zone the main refinancing rate stays at 4.0%.
c. The rate parties receive for deposits at the CB. In the Euro zone – 3.0%.
2. Open Market Operations – a way of controlling money supply. Central banks can do that by buying or selling securities, repurchase operations, and foreign exchange transactions.
3. Capital Requirements – commercial banks are required to hold a certain percentage of their assets as capital, at a rate which may be established by the central bank or the banking supervisor.
4. Reserve Requirements - many banks are required to hold a percentage of their deposits as reserves, usually as a legal requirement. Even if reserves are not a legal requirement, prudence would ensure that banks would hold a certain percentage of their assets in the form of cash reserves. It is common to think of commercial banks as passive receivers of deposits from their customers and, for many purposes, this is still an accurate view.
5. Exchange Requirements – In order to better control money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially-convertible currencies.
Obviously, central banks’ operations affect currencies. It is crucial to follow announcements and publications of the major central banks around the world.
Feel free to contact me with any question or comments.
Adam Narczewski
X-Trade Brokers Dom Maklerski S.A.
adam.narczewski@xtb.pl