A nation’s central bank sets the monetary policy to promote sustainable economic growth by controlling the money supply. The central bank has specific mandates to keep the economy neither too hot nor too cold. Generally, the mandates are price stability (keeping inflation under control), maximum employment and financial stability (basically maintaining the financial system stable).
A central bank has several tools to achieve its goals like setting short term interest rates, adjusting the reserve requirements, and engaging in open market operations (buying and selling of financial assets, mainly bonds).
A monetary policy can be either expansionary or contractionary. The central bank pursues an expansionary monetary policy when the economy is experiencing a slowdown or even a recession. In this case the central bank generally lowers the short-term interest rates, making money cheaper to borrow and thus getting businesses to invest and households to spend.
When the central bank pursues a contractionary monetary policy generally it aims to slowdown the inflation rate if it exceeds their usual target per year. When the economy’s growth rate is above the usual long-term trend it generally causes the inflation rate to rise as there’s a high demand that may be outpacing the supply which ultimately makes businesses to increase their prices and households to demand higher wages. In this case the central bank generally increases the short-term interest rate to put a lid on consumer spending as money becomes more expensive and businesses have to pay higher interest rates to borrow.
Let’s see the main tools a central bank has at its disposal to achieve its mandates:
· Interest rates: the central bank cannot directly set interest rates for loans like mortgages or personal loans, but it influences the interest rate the banks charge each other overnight. By influencing this rate at which the banks borrow from the central bank, it influences also all the other rates because banks pass these costs to their customers. If the central bank sets interest rates higher, then you will see banks charging a higher interest rate making money more expensive and vice versa if the central bank sets interest rates lower.
· Open market operations: the central bank conducts open market operations daily. This is basically the buying and selling of short-term securities and its goal is to maintain the interest rates at the desired level and maintaining the financial system stable. By buying short term bonds the central bank gets the security from a bank and credits cash to the bank therefore increasing the money supply and decreasing the interest rate. On the other hand, when the central bank sells the short-term bonds to the bank it takes cash out of the system and gives the security to the bank therefore decreasing money supply and increasing the interest rate.
· Reserve requirements: banks have to keep a certain amount of their funds in reserve. This amount is decided by the central bank and it’s another tool to control the supply of money in the economy. If the central bank increases the reserve requirement, then the bank will have less money to lend therefore decreasing the supply of money and if it decreases the reserve requirement the bank will have more money to lend therefore increasing the money supply.
· Quantitative easing: in hard economic times when the central bank cannot spur growth by just lowering short-term interest rates, it institutes a quantitative easing (QE) programme. This is basically a large-scale asset purchases programme where the central bank buys various government securities with different maturities to lower both short-term and long-term interest rates. For example, the Federal Reserve bought lots of Mortgage-Backed Securities (MBS) during the GFC (Global Financial Crisis) in 2008 to save the housing market and it bought a large amount of Treasuries and MBS during the Covid Crisis in 2020/2021.
· Forward guidance: the central bank can influence market expectations and thus interest rates by its public announcements about possible future policies. Central bank statements and its members’ comments move markets the most and those who can foresee in advance the central bank moves will profit consistently.
This article was written by Giuseppe Dellamotta
