What is a Central Bank?
A Central Bank is an institution that provides financial and banking services to both commercial banks and the government within a country or currency union. While Central Banks’ remits vary from country to country, their purpose is to provide various forms of financial control through the management of money supply, interest rates and currency.
In the UK, the Bank of England is operationally independent to the government, yet its targets are often set by them. This allows the Central Bank to use its tools and unique powers to meet targets set, free of constant government interference.
What is the purpose of a Central Bank?
As the overseeing bank in a given country or currency union, Central Banks have a range of responsibilities that can only be enacted by a strong central authority with powers to dictate and implement monetary policy.
Central banks are usually tasked with keeping inflation low. In the UK, for instance, the government sets the Bank of England an inflation rate target of 2%.
Inflation is an important concept that’s often ignored by savers and investors. Inflation measures the rate of price growth for general goods and services by monitoring the value of an extensive shopping basket of items.
Inflation gauges how these prices fluctuate over time. In a healthy, growing economy, consumers and businesses spend more, and this increased demand pushes up prices. As demand weakens, so does prices growth and the economy enters a period of disinflation, before deflation – falling prices – takes hold.
Why is inflation important to savers and investors? Well, it reduces the purchasing power of cash over time, so any money sat in a savings account with negligible returns will be losing real value.
To keep inflation within the correct boundaries and avoid too much fluctuation of prices, Central Banks must use the tools at their disposal – largely changes to interest rates and quantitative easing – to control the supply of money in the economy.
What does a Central Bank do?
To ensure they can carry out their responsibilities and meet government targets, Central Banks have various special powers.
Monetary policy: controlling the money supply
Controlling interest rates is a crucial tool used by Central Banks to keep inflation at the required rate. Shifts in this rate have a drastic impact on consumer spending and borrowing.
Changes in the interest rate directly impact the returns on savings accounts and the cost of borrowing – whether the interest earned on fixed income or the interest you pay on debt from a high street bank.
In the UK, the Bank rate (also known as the base rate or interest rate) is the most important interest rate set in the UK. It is the interest rate the Bank of England pays to commercial banks that hold money with it, and influences the rates those banks charge people to borrow money or the interest earned on savings. For this reason, it also impacts the return investors can get from the fixed income market.
Changes to interest rates affect how much people spend, which influences how much things cost. Ultimately, changes to interest rates impacts prices and inflation, the building blocks of the economy.
If rates fall, the cost of borrowing gets cheaper and the return you can earn from your savings falls, which encourages people to spend. If rates increase, the cost of borrowing increases, but so does the return you get from savings, which encourages people to spend less.
Trading government debt
Central Banks buy and sell government debt in the open market to regulate the money supply. This impacts the base rate. Often referred to as Open Market Operations, Central Banks will buy government securities if it wants to increase money supply. If the Central Bank wants to decrease money supply, it sells bonds from its account, removing money from the economic system.
This action mainly comprises trading government bonds. Quite simply, buying bonds increases monetary supply and encourages banks to lend more. Central banks selling bonds reduces the monetary supply which is helpful for reducing inflation.
Quantitative Easing (QE)
Central Banks have another tool in their monetary policy arsenal; quantitative easing. This is an expansion of open market operations. If the bank rate is low but inflation is on course to fall below the government’s target, Central Banks can inject money straight into the economy to encourage spending.
The Bank of England, for example, will create new money electronically to buy investments like government bonds. By lowering the cost of borrowing and increasing asset prices, spending should increase.
Central banks increase the money supply by purchasing assets with newly created bank reserves in order to boost bank liquidity.
This is a unconventional form of monetary policy used for the first time after the financial crisis – the Bank of England introduced QE in March 2009.
Act as the ‘lender of last resort’
The lender of last resort pretty much does what it says on the tin. Central Banks have the power to lend money to financial institutions that are struggling and have no other lenders to turn to – and this role is usually filled by a country or currency union’s central bank. Whilst some Central Banks have this power, it won’t be used lightly.
The reason central banks need to keep commercial banks afloat during times of crisis is to avoid panic setting in which could worsen the entire economy. By keeping liquidity in the financial system, a central bank can prevent people withdrawing their money from the affected bank en masse (a run on the bank) – an issue which can quickly spread to other banks, compounding the problem.