Central Bank questions are some of my favorite. The mysterious world of Central Banking has been spoken about a ton lately with the Federal Reserve of the United States currently trying to raise interest rates off of their all-time lows.
There are many policies the Central Banks of the world can enact to do pretty much whatever they want. If they want inflation to be higher, they can enact certain policies that almost guarantees inflation grows as an example.
During a webinar last night, we received the question, “which best describes what a central bank uses monetary policy to do?” The reality is that when Central Banks use monetary policy, they can do whatever they want to do as they are not governed by any Government bodies and are free to do as they please as they answer to nobody.
Throughout the rest of this article, we will discuss Central Banks, how they came to be, and exactly what monetary policy means and how it is implemented by these private entities, as well as answer the question “which best describes what a central bank uses monetary policy to do?”
A Central Bank, also known as a Reserve Bank or a Monetary Authority, is an institution that is in charge or a nation’s money supply, currency, and interest rates.
Although not specifically an act of monetary policy, Central Banks also oversee commercial banks. An example of this would be the Federal Reserve overseeing the likes of JPMorgan and Bank of America. The difference between Central Banks and these commercial banks is that the Central Banks are the only types of banks that can increase or decrease the money supply of a nation whenever they want. In effect, Central Banks have a monopoly on the countries money supply that they represent.
Besides setting the national money supply via monetary policy, Central banks also manage interest rates, set reserve requirements, and act as liquidity providers in times of financial needs. In effect, in times of financial turmoil, banks and institutions go to Central Banks for liquidity (loans) because Central Banks are the only ones that have the authority to print money at any given time. This is why they will always be able to provide excess liquidity when needed.
Their ability to set monetary policy whenever they please is somewhat concerning as all Central Banks are not governed or regulated by any third parties. The in effect answer to nobody but themselves.
The original goal of monetary policy was to control the money supply to maintain a set inflation rate or interest rate to ensure price stability and increasing prices over time.
The above is what Central Banks mandates are supposed to be. However, over the years and with each crisis, Centrals Bank’s roles have expanded. For example, falling under the umbrella of monetary policy is now contributing to economic growth by adding more money into the system, lowering unemployment, and maintaining exchange rates with other currencies.
What Types of Monetary Policy Do We Usually See?
There are two types of monetary policy decisions the world has seen over the last ten years or so. Both of which can be seen as expansionary policy.
First, we saw a reduction of interest rates.
Above is a chart of the Fed Funds rate, an overnight interest rate to be paid by institutions that are required by law to keep capital reserves deposited at the Fed. We can see since January 2009, the Federal Funds rate is lower than it has ever been.
This is our first example of an expansionary monetary policy. When interest rates are lower than normal, it is easier for institutions to borrow money. This creates an economy that sees an influx of capital and thus this type of monetary policy expands the money supply of the nation. The goal of this type of policy is to:
- Increase employment by allowing business easier access to capital to expand and grow
- Increase demand and inflation
- Boost growth and GDP
Again, this type of monetary policy where interest rates are lowered allows more institutions to borrow money at lower rates. This creates an influx of capital into the system, and more money is available. However, while more money is available, it does decrease the value of the currency involved.
But What Else…?
The second kind of monetary policy we have seen over the last few years is the Central Banks asset purchase programs Over the last few years, the Fed has bought tens of billions of US Treasury Bonds every single month.
But what does this do?
Firstly, it is also expansionary as the Fed is expanding the money supply by indirectly loaning the Federal Government money by purchasing their bonds.
Remember, when investors buy bonds, the price of the bond goes higher while at the same time the interest rate of that bond decreases. When the Fed purchases hundreds of billions of dollars of bonds, it drives interest rates down even further because the price of those bonds rose.
Fixed income investors were then left with two options. They could:
- Continue to purchase fixed income products at their lowest yields ever
- Discontinue purchasing fixed income products and use that money to purchase equities with yield
And what was the result of this? Investors who want to make any yield HAD to buy stocks. The yield on the S&P 500 became larger than the yield of the 30 Year US Treasury Bond. Thus it attracted a lot of capital that would otherwise be purchasing those bonds.
And what did that do to the system? It created trillions of dollars of wealth as asset prices rose without hesitation or any sizeable drawdown.
These two monetary policies allowed institutions to borrow more and more money for cheaper rates of interest while at the same time giving those who borrowed money only one option; invest in equities.
Which Best Describes What a Central Bank Uses Monetary Policy to do?
In short, over the last few years, Central Banks have used monetary policy to increase asset prices at all cost.
Before the extremely accommodating monetary policies were put in place, the United States was smacked upside its head by a collapse in assets prices and an ugly recession. Because Central Banks are able to be puppet masters as they are solely responsible for setting monetary policy and answer to nobody, they were able to drive interest rates down to all-time lows while at the same time giving investors only one option; to purchase equities.
Now, these monetary policies have been in place for a long time and have been expansionary this entire time. Only recently have the Central Banks and specifically, the New York Fed began to enact policies that are contractionary in nature.
If interest rates are reduced, more people have access to cheaper money thus the system is flooded with extra liquidity and capital. This is expansionary.
On the other hand, The Fed has just raised interest rates for the second time in a few months. As interest rates go higher, fewer institutions and banks will be able to borrow the same amounts of money they were able to when interest rates were lower. This removes the continuous capital injections into the system that were seen with lower interest rates.
When the extra capital was added into the system, the currency decreased because there was more supply. However, when interest rates rise and capital is added to the system at a smaller rate, the value of the currency increases because there is less supply.
Wrapping it all Up
Central banks use monetary policy to expand or contract the money supply