In this section, we will discover Central Banks and their tools to influence the economy.
A Central Bank is an independent government authority that manages the macroeconomic objectives (growth, employment, inflation, consumption) of a country or a group of countries by taking some measures of economic control.
Central Banks are non-profit, public institutions whose leaders are appointed by the government. Any money they make from their activities is used for government activities or saved into the country’s reserves.
Central Bank Actions
Governments use three major tools (or levers) to steer the economy: Monetary Policy, Foreign Currency Reserve, and Fiscal Policy.
Now, let’s look at the two tools that Central Banks are in charge of:
The action a Central Bank takes to influence the amount of money in the economy and how much it costs to borrow that money. In other words, the supply of money and the cost of debt are administered by Central Banks and can either spur or check an economy’s growth.
The Mechanisms from Monetary Policy
Central Banks have three main mechanisms to administer monetary policy:
Think of this as control of the cost of borrowing.
The overnight borrowing rate for financial institutions from the Central Bank, which sets a tone for ease of borrowing and economic growth.
As we have seen in previous sections, interest rates are based on the federal funds rate, which is the name of the US policy rate, set by the Fed (US Central Bank). Changes in the federal funds rate (or even expectations of changes) directly impact the demand for loans, money supply (which affects employment, output and demand), and currency strength (which helps drive exports).
The Central Bank can choose to decrease policy rates to stimulate the economy in turbulent times (like in the 2008 crisis in the US) or increase them to slow the economy down when economic bubbles are forming (like in 2018).
Open Market Operations
Think of this as the control of the amount of money.
This helps control the supply of money in the markets and it is the purchase or sale of securities in the markets by governments. This is also known as quantitative easing.
Central Banks can create money digitally to buy corporate and government bonds (more on those later), which is known as asset purchase or quantitative easing (QE). When interest rates can’t be lowered anymore (if they reached near 0%), Central Banks have used this practice to inject cash flow into the economy in extreme times, such as in 2008.
Think of this as a measure to ensure bank liquidity in tough times.
The amount of funds (money reserves) that banks and other financial institutions are required to hold at a Central Bank as a percentage of their total deposit liabilities. This changes the overall amount banks may use for lending or investing. An increase in reserve requirements by the Central Bank would mean more of a bank’s money is tied up and can’t be used for lending or investing, which would increase interest rates for borrowers to make up for that.
Foreign Currency Reserves
Some countries accumulate large amounts of foreign currency reserves; for example, China, Japan, Saudi Arabia, or Norway have trillions of US Dollars in their reserves. These reserves are used to maintain a stable foreign exchange (FX) rate into and out of the domestic currency, to maintain liquidity and confidence in the local markets, and to fund external obligations and internal infrastructure.
Central Banks as Institutional Investors
Central Banks are key for global finance in pretty much every asset class. When investing, they look for the following:
Foreign reserves may be so huge that investing or divesting them could lead to market distortions, so liquidity is extremely important.
Since they deal with public funds, they look to take little unnecessary risks, choosing safe investments such as high-grade bonds or blue-chip stocks.
Central Banks look to generate gains that beat their benchmarks.
Biggest and Most Important Central Banks
Let’s see some of the largest and most influential Central Banks in the world:
- The Federal Reserve (US) – FED
- European Central Bank (EU) – ECB
- The Bank of England (UK) – BoE
- The Bank of Japan (Japan) – BoJ
- The People’s Bank of China (China) – PBoC
- Reserve Bank of India (India) – RBI
- Swiss National Bank (Switzerland) – SNB
- Bank of Canada (Canada) – BoC
- Reserve Bank of Australia (Australia) – RBA
- International Monetary Fund (World) – IMF (the central bank to central banks)
Sovereign Wealth Funds
A Sovereign Wealth Fund (SWF) is a state-owned investment fund established from foreign currency reserves. Some countries’ foreign currency reserves increased so much that they needed to diversify into alternative assets. For instance, China owns over $3 Trillion in foreign currencies and they use Sovereign Wealth Funds to invest it:
- Hedge Funds
- Private Equity
- Infrastructure and Real Estate
- Direct Investment
Some of the best examples of SWF include Singapore’s GIC, Norway’s Oil Fund and Abu Dhabi’s ADIA.
They differ from Central Banks in the fact that they do not have any of the regulatory and monetary policy responsibilities while being 100% government-owned.
In the next section, we will discuss the other major government macroeconomic tool, Fiscal Policy.