The role of Central Banks
Central banks are at the heart of the financial system of any given country in that they are the authorities controlling the supply of money, and therefore control how a region’s economy functions. They evolved from the lack of stability in financial market that ruined a lot of economies during the 19th century. The first central bank was the Swedish Riksbank, which was created in the 17th century, with many following in the 18th and 19 century. The U.S. Federal Reserve appeared at the beginning of the 20th century. Over time, the roles of central banks in different countries have developed differently.
The European Central Bank's main duty is to assure price stability, by keeping "inflation rates below, but close to, 2% over the medium term" as measured in their CPI.
The Federal Reserve of the United States has four responsibilities: 1. Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates 2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers. 3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets. 4.Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system
The Bank of Japan states: "currency and monetary control shall be aimed at contributing to the sound development of the national economy, through the pursuit of price stability."
The Bank of England's mission is to assure stable prices and confidence in the currency through monetary policy and to detect and reduce threats to the financial system as a whole through financial policy
Even if in practice, central banks roles may sound different and even complicated, in pure theory their role is to increase the expansion phase of business cycle and reduce the contraction phase while still assuring future and prospective growth. These targets can be affected through monetary policy conducted by central banks via economic levers like interest rates, open market operations and reserve requirements. In order to conduct them, central banks must hold foreign reserves and gold reserves.
Interest rates are the most important economic lever that a central bank can control. In a classic economy, interest rates are viewed as "the price of money". A high interest rate will attract foreign capital and a low interest rate will tend to force capital to move outside the country in a search for a better income source (higher yields). Forex traders experience this by carry trading. We borrow in Yen, paying a 0.5% annual interest rate and buy, or go long in GBP, EUR, AUD or NZD because those currencies have higher rate of interest, or yield. Lower interest rates will boost lending because it makes the price of borrowing cheaper, giving corporations the ability to grow and giving consumers the "free hand" for spending. Over time this will create inflation and tend to cause interest rates to go up.
The central banks choose their desired interest rate in organized meetings, through voting on the short term interest rate. There are two types of interest rate that we should be aware of, they are; the nominal interest rate, and the discount interest rate from which central banks offer lending to commercial banks. Open market operations (OMO's) are one way a Central Bank controls interest rates. OMO's are simply a buying and selling operation that raises or lowers the money supply, which has an immediate effect on the interest rate and on currency valuation. Each central bank has its favourite way of influencing the interest rate through open market operations, but because of being the simplest and the most influential, we will focus on the Fed's method.
The Fed choose nominal interest rate (named fed fund target rate) through lending and borrowing for collateral securities from 22 banks and bonds dealers (called primary dealers). These operations are nicknamed "Repo" (repurchase operations). Traders should check the open market operations from time to time; they have a significant influence over forex. Most major central banks, including the FED, ECB, BoE, BoC and others use the 'corridor system' to stabilize the intraday money market conditions. In its simplest form, the 'corridor system' allows central banks to attract deposits and provide liquidity in an unlimited amount for overnight operations. This system allows banks to achieve the target overnight rate without creating volatility by channelling (a corridor) those deposits and withdrawals in a very controlled fashion. The discount window is for short-term Institutional lending, normally week-to-week.
Open market operations are the buying and selling of US Treasuries. These daily transactions control the supply of money. Treasuries are Government Debt that is sold to investors at a set rate of return. About half of the US debt is held by the Federal Reserve, a fact that seems strange to some; the Central Bank owns half the Country's debt. The reason is that the Fed can then control the flow of available Dollars. When Rates are required to go up the Fed buys back the Debt. When Rates need to go down the Fed sells Debt with the $ reserves, money that then goes into the banking system. Rates going up creates a squeeze on the Money Supply and the $ strengthens. Rates going down therefore increases the Money Supply and the $ weakens.
Minimal Reserves are another way of influencing the money supply used by central banks. Commercial banks are required to hold a percent of their liabilities in central banks, in order to avoid over-levering themselves. This is a good measure of reducing money supply or trying to increase money demand. This is arguably the most ineffective and definitely the least used monetary tool. Reserve requirements are the percentage of deposited money that a bank must keep on hand to satisfy withdrawal demands, and was more popular in the early part of the 20th century when the US banking system was far less stable, but that challenge may be coming back to be addressed. In theory raising reserve requirements limits a bank's ability to lend out deposited money, and likely increase the cost of borrowing.
Paying no interest on Reserves, as is the Fed policy, makes U.S. Banks hold no more than they are legally required to do, and with any and all cash surplus then lent to other Banks in times of need, usually underneath the Fed Funds rate (Discount Window), it puts additional and unwanted pressure on the system. This pressure can be very negative, especially when the Central Bank, in this case the Fed, is in a rate changing cycle. Banks borrowing under the Fed Funds sends rates down, at a time that the Fed needs them up to be able to fight inflation. We have witnessed the volatility in the Treasury yields, in the Libor rates, and seen it reflected in the intra-day volatility in the USD/CHF.
That is the problem when the Central Bank has a dual mandate, in reality you can either fight inflation, or you can have growth- but growth at a dear price, as we can see in the Commodity Bubble; the value of any growth produced is stripped away in inflationary costs.
A good example of the reserve Requirement has been seen in how the People's Bank of China tried to reduce inflation by increasing bank minimal reserves requirements nine times. The central bank has also moved five times in five months to increase the reserve requirements. They stepped up the rate of increase with two extra moves in late June that increased the mandatory holdings of dollar reserves, from 15% to 17.5%, of anything that is lent out by commercial banks. The impact has been to peg the Yuan lower, and in that in effect has eased the burden of Chinese exporters struggling with a global economic slow-down.
It is estimated that just under $50B was moved in that year in June alone, and will be added to by the cuts to the amount of foreign debt Chinese banks can hold, once again forcing those banks to be net buyers of dollars. China’s foreign reserves stand at close to $1,800B, and moves in that market will have knock-on effects to all global forex markets.
Monetary policy controls the supply and cost of money and credit. A central bank will increase the supply of money and decrease the cost of borrowing to stimulate an economy and vice versa to slow down an economy. While measuring the cost of borrowing is fairly easy (yield on Treasury bonds), measuring the money supply can be a more daunting task. Most central banks release information on the amount of money currently in circulation. M1 measures the amount of currency, deposits in central banks, and checking deposits. M2 includes M1 and all money in CD's and savings and money market accounts. M3 includes M1 and M2 as well as US denominated Bonds held outside the US. M3 is the broadest measure of the supply of money. Recently the Federal Reserve decided to stop publishing M3 data, citing the large cost of computing the figure. The move has been widely criticized, as many believe it was initiated to hide the large amount of money the Federal Reserve has been printing in recent years.
Even though a central bank needs to be as independent as possible, governments and politicians still have influence in its aims and targets. Depending on the country, a central bank's president or commission is set by the government which sometimes may have influence on bank's decisions at turning points, like at the peak of business cycle or during elections. The Finance Ministry of Japan is an example of a dominant government body influencing the central bank.
One of the major requirements of the European Union for proposed countries for acceptance, is that the Central Banks are independent from politics. With all this, central banks and government must choose their real economic targets, by trying to choose the best way for their own national economy, and as we have seen recently that can create some huge swings in perceived currency valuations.
Reference: The LFB Trade Team