How Central Banks Affect Markets

Introduction

Central banks are the driving force for most economies. They play an important role in the growth and sustainability of societies, using a variety of tools to keep all broad monetary aspects in check.

Some central banks are more known than others, such as the Federal Reserve (also known as the Fed), the central bank of the US, and European Central Bank (ECB), the central bank for the Euro Zone. Other key central banks include the Swiss National Bank, the Bank of England, The People’s Bank of China, and the Bank of Japan.

Central banks ensure the health of the economy of that country by regulating the amount of money available in circulation. They also change interest rates, print money as needed, and set reserve requirements for banks to control the supply of money. Other tools that are used by central banks include open market operations and quantitative easing which is the act of buying or selling government bonds and securities.

Why does the amount of money matter? Money circulating within an economy affects micro-economic and macro-economic trends. Starting with the micro, a large supply of money allows for more spending by people and businesses as well as obtaining loans and securing financing by companies.

Central Bank Tools for Managing Money Circulation

Gross Domestic Product (GDP), interest rates, and unemployment rates are all affected by the amount of money circulating. Central banks control this money flow to achieve certain objectives and influence monetary policy using six tools: 

1. Printing Money

One of the main tools that central banks use to control the amount of money in circulation is printing as needed. While it’s not the main method or the preferred one, it is still used occasionally to tackle certain scenarios. Printing more money does not always directly affect economic output and can cause inflation—so there are consequences to using this tool.

2. Reserve requirements

This is a more common tool used by all central banks. Reserve requirements require that commercial banks maintain a certain amount of money relative to their deposits. This money is held in vaults or at the central bank. 

For example, assume a central bank has a reserve requirement of 10% and a commercial bank has deposits worth $100 million, the bank needs to set aside $10 million as a reserve requirement while being able to circulate the remaining $90 million.

Adjusting the reserve requirement is common practice. When the central banks raise the requirements, they are technically telling banks to circulate less and put aside more. When the central banks drop the requirement ratio, they are allowing banks to circulate and loan more while putting aside less.

3. Interest Rates

While central banks do not set the rate for personal loans, mortgages, and other commercial borrowings, they can adjust he rate that commercial banks can borrow money from the Fed. In the US, this is referred to as the federal discount rate. 

When banks can borrow cheaply from the central bank, they are able to pass on those savings to their customers. Furthermore, lower rates fuel an increase in borrowing, leading to an increase in the money supply.

4. Open Market Operations

Open market operations refer to central banks buying or selling government securities. When central banks are looking to increase the money in circulation, they would buy government securities from banks and institutions. 

The transaction results in commercial banks having more cash, which they can use to loan to their customers. This is usually seen as an expansionary or easing monetary policy, leading to lower interest rates.

5. Quantitative easing

During difficult economic times, central banks can introduce an upgraded version of the open market operations by launching a quantitative easing program. In this situation, central banks create more money, they then use it to buy government securities. 

The newly entered money improves the money supply and allows banks to give out more loans, which leads to lower interest rates.

6. Currency intervention

At times, central banks may decide to strengthen or weaken their own currency for different reasons. Two popular examples include the Bank of Japan and the Swiss National Bank who, over the years have intervened in the markets to weaken their currencies on multiple occasions. 

The Japanese Yen and the Swiss Franc are considered safe-haven currencies which leads to strong demand especially during times of uncertainty. At this point, the central bank may look to sell their own currency and buy other foreign currencies using very large amounts that could influence the market and change the exchange rate. 

In Figure 1, you have the Daily USD/JPY chart showing intervention on March 18, 2011, and its results. 

Figure 1

There have been other interventions over the years but it’s an extreme measure that is taken only when an exchange rate is reaching dangerous levels in relation to the economic activities of the country.

Conclusion

Using a variety of tools, central banks can control the amount of money in circulation to either stimulate the economy or ease inflation. Although they are often criticized for their decisions, there are many other moving parts that influence the economy of an entire nation.