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LISTEN TO THIS ARTICLE:Central banks play a crucial role in the world of finance and investing. They all have a mandate that differs from country to country and from jurisdiction to jurisdiction.
Respecting the mandate is the top priority. As always, there’s a thin line between what’s in the mandate and whether the central banks’ actions respect it, but as recent history has shown us, central banks are so creative in defining what fits the mandate that their power is almost limitless. Note the word “almost.”
As this article reveals, some central banks are more important than others. For instance, national central banks in the Eurozone (e.g., the Bundesbank in Germany or Banque du France) play a limited role in today's financial markets compared to before the European Central Bank (ECB) came into existence. At the opposite end of the spectrum, the Federal Reserve in the United States (Fed) is viewed as the most influential central bank in the world.
Moreover, there's one entity, called the Bank for International Settlements (BIS), that governs the actions of all national/regional central banks. Essentially, BIS acts as the mother of all central banks.
We're here to present the mandates of central banks and their role in the current financial system. This is not the only article in this trading academy dealing with central banks, and for a good reason: The subject is so vast and important that we'll address some of the topics in more detail so that traders have all the information they need to build a comprehensive picture.
The central banks representing the main currencies of the Forex dashboard are all independent. That means they don’t respond or react to governmental instructions and focus only on fulfilling their mandate.
Some have a simple mandate, some a more detailed one. Get ready to dive into the fascinating world of central banking.
Understanding Money Supply
The main task of central banks is to control the money supply in the economy. Money is defined as the currency in circulation plus the deposits that exist at commercial banks.
When central banks conduct monetary policy, they take action that affects the aggregate output in the economy. But their actions also influence the prices in the economy. They conduct monetary policy by changing the bank reserve ratios, the reserve requirements, or even the target interest rate.
Speaking of bank reserve ratios, most countries have a fractional reserve banking system. Effectively, that means that every commercial bank must have certain reserves. Typically, the minimum amount to hold is the required reserve ratio times the customer deposits.
If a commercial bank doesn’t have enough reserves, it can borrow some from the interbank market at the interbank lending rate set by the central bank. Following the same logic, commercial banks with excess reserves can lend them to other banks who need to raise their reserve level.
A central bank decreases the money supply (i.e., the quantity of money in an economy) by selling securities previously purchased from commercial banks, raising the required reserve ratio, or raising the target for the interest rate at which banks borrow and lend reserves among themselves.
In taking one or all these actions, the central bank shrinks the amount of available money in the economy. Called monetary policy tightening, this action has a positive impact on the domestic currency, as suddenly, money is not readily available anymore.
On the other hand, when the money supply increases as a result of a central bank's actions, the local currency suffers. It's a negative for the currency because more money is available at cheaper rates.
Targeting the Interbank Lending Rate
Some central banks (but not all) choose to target a certain level for the interbank lending rate. This is the case with the most influential central bank in the world – the Federal Reserve of the United States (Fed).
In doing so, the Fed adds or drains reserves by conducting open-market operations to maintain the target interest rate, allowing them to implement monetary policy decisions effectively. Examples of open-market operations include buying or selling government bonds, taking actions on the repo market, and so on.
If the Fed raises the target interest rate, reserves will shrink, thus making them more expensive in the interbank market, which is positive for the currency. On the other hand, if it lowers the target interest rate, reserves will expand, becoming less expensive on the interbank market, which is negative for the currency. In other words, there's a powerful correlation between open-market operations and interest rate targeting.
The Significance of Inflation
At the heart of each central bank’s mandate is inflation. Strongly related to the value of money, inflation shows the price-level changes during a given period. It is worth mentioning here that inflation is pro-cyclical, meaning that it moves in a strong correlation with the business cycle.
The business cycle reflects the periods of bust and boom in an economy. In strong economic performance and before the peak of the business cycle, inflation rises with the increase in the GDP. After the peak and during the contraction phase (also called “recession” or “depression,” depending on how severe the contraction is), inflation falls, together with the GDP, as the economy slows down.
Inflation is important for central banks, as it is a gauge of measuring the performance of an economy. Because central banks use money supply to stimulate economic growth, inflation offers a great gauge in determining the value of money.
The inflation rate shows the percentage change in a price index, and price indices around the world usually hold the composition of the consumption basket constant. That means inflation won't change the products and services in an economy, so the price evolution of the basket offers a clear picture of the value of money over time.
When inflation accelerates strongly, the economy suffers from hyperinflation. Hyperinflation is characterized by an extremely high inflation rate, such as over 1000% a year. The cause of hyperinflation is a combination of government spending and a lack of tax revenue. To cope with the spending, the monetary authority (i.e., the central bank) prints more money to satisfy the needs, thus increasing the money supply to an extreme. Logically, the value of money decreases the more inflation increases.
The Typical Central Bank’s Mandate Today
If high inflation leads to a decrease in the value of money, deflation has the opposite effect. When inflation moves below the zero level, it is said that the economy is in a deflationary mode. The currency appreciates in such a case, but that’s not something central banks want to see.
Between inflation and deflation, the latter is more dangerous and difficult to fight. The liability of the borrower also rises in real terms during deflation, and companies see a decrease in revenue. What follows is a cut in spending and investment, and the next thing you know, a mild economic contraction can become a strong recession or even a depression.
To avoid that, a consensus among central banks in the developed world is to keep inflation around the 2% level. Different central banks have different specific figures, but they all agree on a rate below but close to 2%.
We can say that levels like 1.8% and 2.2% are normal. The further the inflation rate deviates from the target, the stronger the central banks’ actions are.
When inflation falls below the desired level, the central bank eases the monetary policy. To do so, it lowers the interest rate level or, as we saw after the 2008 financial crises, engages in quantitative easing (QE). On the other hand, when inflation exceeds the 2% target by more than what the central bank considers acceptable, it engages in monetary tightening. Essentially, central banks act to decrease or drain the money supply in an economy by raising the interest rate.
Consumer Price Index Changes
The Consumer Price Index (CPI) is the most important inflation measurement tool favored by central banks around the world. Because the value of a currency fluctuates with changes in the monetary policy and the monetary policy is influenced by inflation, the CPI is on the top of every currency trader’s list in terms of economic news to follow.
Around the world, CPIs have different release dates and sometimes even a different name. For instance, in the United States, the term “CPI” is used, but the ECB watches the “Harmonized Index of Consumer Prices” (HICP), calculated by Eurostat. It's just a different term, but it still measures inflation.
When traders look at the economic calendar and interpret its data, other inflation indexes, such as the Producers Price Index (PPI), may sound as important as the CPI. However, for central banks, only the CPI is part of the mandate, not the PPI, for the simple reason that changes in prices at the producer level, while important, take a considerable amount of time to be transmitted to consumers.
All developed economies measure the level of inflation, and central banks intervene to adjust the money supply based on the latest changes. But not all central banks have a mandate oriented toward inflation only.
The Federal Reserve in the United States (Fed) targets both inflation below or close to 2% and job creation. Both are part of the Fed’s mandate, making the data from the United States special.
The Fed's Dual Mandate
The Fed in the United States also considers job creation before deciding on the path of its monetary policy. For this reason, the job data in the United States is as important for the US dollar as the CPI.
So far in this trading academy, we’ve covered different forms of job data around the world, especially the releases in the United States. Later, we’ll also look at the Fed and how the most important central bank in the world is organized and functions.
The Fed, as mentioned above, has a dual mandate. Blending job creation with inflation targeting is a daring task. Most of the problems come from the fact that job creation is a complex process, with many unknowns and challenges.
For instance, take the unemployment rate, which shows the number of people actively looking for a job when compared to the total labor force.
When setting the monetary policy, the Fed often uses a threshold as a way of gauging the effectiveness of its measures. For instance, when it ran the fourth round of quantitative easing (QE4) a few years ago, the Fed set a certain target for the unemployment rate. In other words, it ran the QE program until the unemployment rate dropped below a certain level.
So, this is how a dual mandate functions – the Fed sets targets for inflation and job creation and adjusts the monetary policy based on the economic performance. But the unemployment rate is not enough to assess the state of the job market.
To get a clear picture of the entire job market, one needs to consider the labor participation rate as well. The higher this rate, the better the economy, as the unemployment rate considers more participants. On the other hand, a low participation rate coupled with a falling unemployment rate doesn't necessarily signal improving conditions, especially if the number of discouraged workers (people who give up looking for jobs) is on the rise.
Core Inflation
We may say that inflation is the key to the value of money. But even when looking at inflation, some releases are more important than others.
We said that the CPI measures the changes in price levels over a given period. However, the price of oil is a leading inflation driver, and many central banks want to avoid exposure to its volatility. For this reason, core inflation, or core CPI, is often the favorite way to measure the changes in prices.
The core data reflects the changes in prices for the overall goods and services in an economy but excludes transportation and energy prices – basically, everything that is linked to the oil market.
Central banks believe that this way, they will have a better picture of how the value of money changes in an economy from month to month and year to year. In other words, the effects of the price of oil on inflation are viewed as transitory.
However, that’s a tricky statement. For the population, “transitory” may signify a long period of time, while for the central bank, it is just a cycle. When the price of oil dropped shortly after the 2008 financial crisis from $100 to below $30, it sent a deflationary spiral across the world. Seven years later, the world is still gripped by the oil price drop and the effects it had on inflation. Because central banks needed to react by cutting the interest rate and engaging in measures to ease monetary policy, the challenge is to find the balance between real inflation and money supply so that the value of money remains stable over time.
What Is Inflation Targeting?
Inflation targeting was pioneered by one of the most innovative central banks in the world – the Reserve Bank of New Zealand (RBNZ). In 1989, it introduced the platform now common in many jurisdictions in the developed world – targeting price stability via a certain inflation level.
At the time, inflation in New Zealand ran at relatively high levels (above 6%), and the Minister of Finance announced the bank would target inflation at a level of 0–2%. In other words, the RBNZ was free to set the rates for the New Zealand Dollar (NZD) in whatever way it considered useful to reach the inflation target.
The inflation targeting proved to be a success, and other countries followed the RBNZ steps: Chile, Canada, the United Kingdom, and Israel in 1990 and 1991, Spain in 1995, and Norway in 2001. Many other developed countries also adopted the concept.
Each central bank defines its inflation targeting process differently. For example, in the United Kingdom, the Bank of England (BOE) targets a CPI inflation around the 2% level, with an acceptable deviation of +1% or -1%. This is called symmetrical targeting, something many central banks have in common. Sweden has a similar inflation targeting platform.
Conversely, in Canada, the Bank of Canada (BOC) has a CPI target between 1% and 3%. While the range is bigger, a close look at the median value reveals that the BOC has the same mandate – inflation around 2%, with a +1% or – 1% deviation.
Other central banks have similar mandates. They may look different at first glance, but all the mandates revolve around the ever-important 2% level.
Stagflation
Inflation or price stability around a certain level (2%) is the aim of each central bank. When the prices of goods and services in an economy deviate far from the 2% level, phenomena like hyperinflation or deflation arise.
But these two phenomena aren’t the most dangerous things that can happen from a central bank’s point of view. There’s a “medicine” or “cure” – hiking or lowering the interest rate level and/or tightening or easing the monetary conditions using unconventional measures.
The problem comes when the job market also becomes resilient. High inflation and high levels of unemployment lead to a phenomenon economists call “stagflation.” As the name suggests, the economic growth stagnates but inflation simultaneously rises – and, at the same time, the unemployment rate rises too.
Stagflation is challenging to combat for the simple reason that there is no short-term economic policy thought to be effective. The economy is left to correct itself, and it's the population that suffers.
Independence, Credibility, and Transparency
The best way to look at central banks is to consider them the bank of the government and other banks. A central bank also has numerous other roles – we can call them secondary roles.
One secondary role is to maintain full employment. Another is to maintain people’s confidence in the financial system. The rest are along the same line.
But the main role of a central bank is to maintain price stability. Trust in the value of money is what keeps the financial system afloat – and central banks are aware of that.
A central bank must be independent so that it maintains its objectivity. For it to be credible from the perspective of the population, it should not be influenced by the government or politicians. Independence, credibility, and transparency are three mandatory characteristics to maintain people's confidence in the ability of the central bank to control the value of money and reach its mandate – price stability by inflation targeting.
Lender of Last Resort
Lender of last resort refers to central banks acting as a banker to the other banks in their jurisdiction. Effectively, that means that central banks have the capacity to literally print money to fund other banks that are in need of liquidity.
Obviously, printing money is not the preferred way to conduct monetary policy, and the general public won't like it. Thus, central banks always need to be aware of the health of the banking system and how commercial banks are performing.
For this reason, especially after the 2008 financial crisis and the Eurozone crisis, many central banks around the world run stress tests on the commercial banks in their jurisdiction. These tests are meant to demonstrate the commercial banks’ ability to endure crises, contractions, recessions, and even economic depressions.
As always, that requires better preparation for difficult times. Because the business cycle repeats, recessions will always appear on the horizon. The aim of a central bank is to make the most of the expansion part of the cycle and then make sure the eventual economic contractions are as mild as possible and do not transform into recessions or full-blown depressions.
The idea of the lender of last resort has the effect of building trust. If the population knows that the central bank may act as a lender of last resort and stands ready to provide liquidity, they might avoid bank runs.
The term “bank run” refers to the phenomenon where people withdraw money from a bank in large quantities. Remember that under the fractional reserve system, banks don't have enough money to satisfy all withdraws. Thus, when people suddenly want to withdraw their money in large quantities, the bank faces difficulties satisfying the demand. However, if the central bank acts as a lender of last resort, it may provide enough liquidity when needed.
Objectives and Supervision
Besides setting the monetary policy, central banks are responsible for maintaining and managing the country’s foreign currency reserves and gold reserves. It should come as no surprise that each central bank has a trading department in charge of applying the central banks’ decisions and implementing trades to manage the reserves.
As the US dollar is the world’s reserve currency, most foreign central banks prefer to keep their reserves in dollars. The Euro and the British Pound are also favored, albeit in much smaller percentages.
Despite the world abandoning the gold standard, central banks still go to extra lengths to build and manage gold reserves. For example, the Bundesbank in Germany has undertaken the complex and extremely costly operation to repatriate the gold reserves from the United States back under German soil.
The supervision of the payment system is another important role of central banks. Target 2 in the Eurozone is a successful example of how a central bank can integrate and oversee the payment system in such a way to coordinate payment systems internationally with other central banks.
A central bank typically supervises the commercial banks under its region (nationally or regionally, as in the case of the ECB). However, they are not the only entities that supervise commercial banking activity, as in many countries, different bodies are in charge of banking supervision. Examples include the Financial Conduct Authority (FCA) in the United Kingdom and the Federal Commission in Switzerland.
The Transmission Mechanism Explained
The transmission mechanism is an interesting central banking concept. It deals with how the central bank interest rate gets transmitted through the economy. Before anything, it is worth mentioning here that the transmission mechanism takes some time to implement – therefore, when a central bank changes the interest rate level, don't expect the effects to appear right away. Instead, look for a period of six months or more for the changes to have an effect.
If a central bank cuts the interest rate, it has four channels through which to transmit the cut – asset prices, bank lending rates, exchange rates, and inflation expectations. The first thing that happens after a rate cut is that the interbank rate (the rate at which commercial banks borrow from each other) falls too. As a result, commercial banks lower the cost of borrowing for individuals and businesses, stimulating the economy by offering more favorable lending conditions.
The Official Interest Rate
This rate has a different name from central bank to central bank. In some cases, it is called the main refinancing rate and in other cases the official policy rate or simply the official rate or policy rate.
It is the rate at which the central bank lends money to commercial banks. Commercial banks don't want to lend money to customers below the official rate set by the central bank, so they immediately adjust the base rate they charge.
Commercial banks want to stick with the official rate because the central bank can effectively force commercial banks to accept the new rate by conducting repurchasing operations (repo operations) at a predefined rate unfavorable to the commercial bank if it doesn't align its base rate with the official rate. The repo rates have different names around the world, and the most famous one is the federal funds rate in the United States.
Objectives of Central Banks
As the world's leading central bank, the Federal Reserve of the United States promotes maximum employment, stable prices, and moderate long-term interest rates. It does so by adjusting the federal funds rate based on its inflation target and the ability of the US economy to create jobs.
In Australia, besides the stability of the currency (i.e., the Australian dollar – AUD) and the maintenance of full employment in Australia, the RBA also looks for the economic prosperity and welfare of the people of Australia.
The ECB bases its actions on the Treaty on the Functioning of the European Union. It strives to maintain price stability, implement and support the economic policies in the community, and ensure high levels of employment and non-inflationary growth.
The examples could go on, as each central bank in the world has a similar mandate, albeit formulated a bit differently. What matters is that price stability is key, and so far, the developed world has managed to achieve this goal over the last decades.
It wasn't always easy. People tend to forget that only a few decades back, World War II lead to rampant inflation in Germany. The effects were also seen in other parts of the world, as the demand for goods to sustain the war meant an economic boom in America, for instance. Hence, inflation rose in America too, but for different reasons.
In other words, it is critical to know that central banks keep an open mind and a proactive attitude toward the financial system as we know it. Some people don't give them much credit, but that's mostly due to ignorance and not being aware of what their role is.
The Bank for International Settlements
A special entity, the BIS is owned by 60 different central banks in the world and aims to help them implement the monetary policy. Headquartered in Basel, Switzerland, with branches in Hong Kong and Mexico City, the BIS acts as a counterparty for central banks around the world in their financial transactions.
The representatives of each central bank member of the BIS meet regularly to set the agenda for the period ahead. We can say without a doubt that the BIS acts as the "mother" of all central banks. Also, because the governors, presidents, and vice-presidents of central banks meet regularly under the BIS umbrella, it's certain they all know what the policy changes in other parts of the world will be.
In other words, while market participants may be surprised by, say, the Fed cutting the rates and starting an easing cycle, the other central banks of the BIS were already aware of it. What’s also important is to know that the BIS offers an incentive and umbrella for central banks to work together to contain international crises.
When the Eurozone crisis deepened because of Greece cheating on its GDP reporting, the commercial banks in the Eurozone suddenly experienced a shortage of USD. The Fed quickly offered swap lines via the BIS, giving a hand to the troubled ECB. Similarly, when a tsunami hit the coast of Japan a few years ago, the ECB, Fed, BOE, and other central banks offered assistance via liquidity through BIS channels.
Conclusion
It should be clear by now that the main objective of central banks is price stability around the 2% level. Many argue that the 2% level is arbitrary and does not fully reflect the challenges in an economy, and they may be right.
But so far, capitalism and the current financial system works on the premise that moderate inflation helps economic growth, and economists around the world define moderate inflation as 2%. Hence, the mandate of most central banks uses this number.
However, monetary policy changes. Challenges appear from unexpected areas – many of them unprecedented. For instance, several years ago, if any economist had dared to think a central bank in a developed country setting negative interest rates, the concept would have been deemed impossible.
Yet, now it's the norm. Many major central banks, such as the Bank of Japan (BOJ), ECB, and Swiss National Bank (SNB), have implemented negative rates, with some success – but many side effects. The consensus is that negative rates should be viewed as temporary, but no one really knows what challenges the future will bring.
Modern central banks innovate continuously. In Japan, the central bank was unable to bring inflation to the 2% target for decades. A mix between an aging population and cultural differences is responsible for the outcome. In other words, measures that work in other parts of the world failed to bring about the same results in Japan. Japan is not the only example.
To sum up, central banking is vital to setting the value of money. For currency traders, that’s all that matters when applying fundamental analysis concepts to determine the future value of a currency.
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