What Are Central Banks?

He we are deep in the thick of monetary policy and we haven’t yet discussed what central banks are, or how they work. Let’s get into the details of what a central bank actually is, what it can do, and how it does it.

Central Banks

Central banks are entities which seek to aid in the growth and regulation of whole economies. To put it simply, a central bank wants to make sure that an economy can grow as fast as it can without risking negative consequences like inflation, investment bubbles, or recessions and depressions.

There are many different central banks around the world—each currency has its own. Here are a few of the biggest central banks:

• US Federal Reserve
• European Central Bank
• Bank of England
• Bank of Japan
• Swiss National Bank
• Reserve Bank of Australia

As we said, the central bankers’ job is to “pull the levers” on monetary policy (policies from a central bank that affect the economy) to keep the economy moving as best as it can, whenever it can.

How Central Banks Set Interest Rates

We hear a lot about how central bankers move interest rates. They may increase rates after one meeting, or they might decide to lower them at another. The thing to remember, though, is that central banks cannot just SAY “hey, rates are going down .25%” and get a response out of the market. They have to force the rate cut into the market.

Central banks cut rates by decreasing the price of money. They do this by undercutting all other lenders on the market.

Let’s say the Federal Reserve wants to reduce rates by .25% to .5%. To force this change, it has to increase the money supply so that rates can fall that low. To drop rates to this level, the Federal Reserve creates new cash (not in the form of paper, but mostly electronic digits—most currency is electronic, actually) and throws it into the market.

You see, with an increase in supply, the market adjusts to the Fed’s new target. If the Fed comes in and says to banks, “we’re going to loan any amount of money to you at .50% instead of .75%” then the overnight interest rate drops.

Interest Rate Example

Follow along with the table below to learn how central banks change interest rates:

From the table, we see that the market equilibrium price for money is 4%. At a 4% interest rate, borrowers want to borrow just as much money as lenders want to lend.

In order to push rates to 1%, central banks would have to provide lots of cash to the market. Since there is $100 worth of demand, and only $5 of supply from lenders, the central bank would have to add an additional $95 to cover the difference.

On the other hand, to push rates up to 6%, the central bank will have to take money off the market. Since there is $60 worth of supply, and only $10 of demand, the central bank would have to reduce the money supply by $50.

Central banks increase rates by decreasing the amount of money available. When they want to raise rates they either:

1. Provide less money to the market than they are already
2. Take money out of the market

By decreasing the supply of money, the price of money (the interest rate) goes up. This is fairly simple to understand: when there is less of something (think of a Picasso original painting) it’s worth more. When there is a lot of something (think of a Picasso copy) then these items are not worth as much.

If you’re not entirely in-tune with the mechanics of central bank policy making, don’t fret. In reading this section, you have been exposed to more monetary policy information than the average world citizen. You are already above average.

Just wait until you get it all down pat. By then, you’ll not only be ahead of the curve, you’ll be a ready-to-trade fundamental analyst, as well.