What are Central Banks?

Updated: 2017-10-06 13:47:31 | Author: Order Flow Trading Academy

One of the main drivers of the currency market in particular, is interest rates. Interest rate differentials create the Carry Trade strategy, and they also influence currency trends. Basically, interest rates (and thus, yields) drive money flows, so it's only natural that we would be interested in knowing who commands interest rates. Central Banks command interest rates, and we should get to know them better. Just remember: it's not the actual level of the interest rates that's important; it's the expectation of where rates are going in the future that drives our day-to-day flow in the markets.

what are central banks?

1. What are Central Banks?

A country's central bank is "the lender of last resort", which means that it is responsible for providing its economy with funds when commercial banks cannot cover a supply shortage. In other words, the central bank prevents the country's banking system from failing. How does it do this? Through it's “mandate” which is a fancy word to state it's objective, which nowadays is basically providing the country with price stability by controlling inflation. History has taught us that the central bank can best function by remaining independent from government fiscal policy. The central bank should also be completely independent from any commercial banking interests.

2. Some History on Central Banking

Historically, the role of the central bank has been growing since the establishment of the first central bank: the Bank of England, in 1694. It is, however, generally agreed upon that the concept of the modern central bank did not appear until the 20th century as problems developed in the commercial banking system. Thus, the central bank's modern function emerged in response to an already present commercial banking structure. Between 1870 and 1914, when world currencies were pegged to the gold standard, maintaining price stability was a lot easier because the amount of gold available was limited and inflation was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency, so there was a direct link between a country's currency strength and the amount of gold reserves available.

At the outbreak of the 1914-1917 1st World War, the gold standard was abandoned, and it came apparent that in times of crisis, governments facing budget deficits (funding their military) and needing greater resources will order the printing of more money. As governments did so, they obviously cirumnavigated any consideration whatsoever on price stability in favor of short term necessities – thus creating inflation. How would this happen? The printing of money increases money supply. But since it is exogenous from the actual economy, the prices of goods would rise in monetary terms without there being actual demand to justify these price increases. Of course, the ones that suffer are the people of those countries, not their politicians or their soldiers occupied with war.

After WWI, many governments opted to go back to the gold standard to try to stabilize their economies. With this rose the awareness of the importance of the central bank's independence from politics and fiscal policy. During the unsettling times of the Great Depression in the 1930s and the aftermath of Wold War 2, world governments predominantly favored a return to a central bank dependent on the political decision making process – not learning from the past. This view emerged mostly from the need to establish control over war-shattered economies. Also, the rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the economy. But after seeing the effects of these policies in the years after 1945, the independence of central banks from the government came back into fashion.

3. How the Central Bank Influences an Economy

A central bank has mainly two kinds of functions:

a) macroeconomic when regulating inflation and price stability: being responsible for price stability, the central bank must regulate the level of inflation with monetary policy. The central bank performs open market transactions that either inject or absorb liquidity, directly influencing the banking sector's lending facilities, and through this affecting the availability of credit to the general economy, thus affecting the level of (perceived) inflation. To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can expand it's balance sheet (let's call it a spending spree) by buying government bonds, bills, or other government-issued notes..or even buying less than trustworthy issues (like ABS, MBS, CDS for which there was no market after the Lehman collapse). This buying can, however, also lead to higher inflation expectations. When it needs to absorb liquidity to reduce inflation expectations, the central bank will sell securities in the open market, which increases the interest rate and discourages borrowing. Open market operations are the key means by which a central bank controls inflation, money supply, and price stability.

b) microeconomic when functioning as a lender of last resort: this function has pushed the need for central bank freedom from commercial banking. A commercial bank offers funds to clients on a first come, first serve basis. If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds. This provides the system with stability in an objective way. Central banks cannot favor any particular commercial bank. As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank's deposits. Enforcing a policy of commercial bank reserves functions as another means to control money supply in the market.

The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base rate for interest rates). It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. Use of the discount rate can be restricted by making it unattractive when used repeatedly.

4. Characteristics of most influential Central Banks

ECB: The European Central Bank was established in 1999 and the decisions are made by the governing council. As a young central bank, the ECB does not like surprises and thus, before making any changes to interest rates, it gives the market ample notice by warning of an impending move through comments and speeches. It's mandate is to maintain price stability and sustainable growth. In practice, it's an inflation targeter with a target of 2%. As the Eurozone economy depends on exports to other countries, the ECB also needs to keep the Euro exchange rate under control.

FED: The Federal Reserve is currently the most influential central bank in the world. After all, the US dollar is the main currency used in international transactions worldwide. The decisions are made by the FOMC. Their mandate is to attain price stability and long term growth. They are much more “creative” then the ECB.

BOE: The Bank of England was the first central bank in history, and is currently regarded as a very effective central bank. The decisions are made by the Monetary Policy Council. Their mandate is to maintain monetary and financial stability; practically speaking, they are inflation targeters with a target of 2%.

BOJ: The Bank of Japan is definitely one of the more active central banks in the world. After all, their economy is largely dependent on exports, so the BOJ feels free to intervene when the Jpy gets too strong. It also makes itself unusually visible when “checking rates” to induce the market into thinking that something is up. Finally, it is very verbal when addressing excessive currency movements. It's mandate is to maintain price stability and ensure the stability of the financial system. The BoJ is an inflation targeter as well. The decisions are made by the Policy Board.

RBA: The Reserve Bank of Australia also has a similar mandate to the other central banks. They must ensure the stability of the currency, maintain full employment and economic prosperity and welfare of the people of Australia. Their inflation target is 2-3%.

RBNZ: The Reserve Bank of New Zealand is a little more peculiar. The decision making power rests with the central bank governor and not with any “board.” The mandate of the RBNZ is to maintain price stability and to avoid instability in output, interest rates and exchange rates. The RBNZ has an inflation target of 1.5% and it focuses hard on this target because failures can result in the dismissal of the governor.

BOC: The decision making process of the Bank of Canada is made by a consensus vote of the Governing Council. The BoC is also an inflation targeter and it's mandate is to maintain the integrity and value of the currency. The inflation target is 1-3% and the BoC is one of the most effective central banks because it has done a good job of keeping the inflation rate in this band since 1998.

PBOC: The People's Bank of China is the new guy on the street, but do not take it lightly as it has the most financial assets of any public finance institution in history. China is also the second largest global economy, and it should not surprise that PBOC is secretly among the largest buyers of gold. The monetary policies of the PBOC are slightly different to most central banks. The PBOC is under control of the Communist Party and can dictate the Chinese economy through the commercial banks. The PBOC has a dual mandate: promote economic growth and keep inflation low. It should be remembered that 30% of the Chinese CPI consists of food, compared to 8% for the US. The PBOC monitors food prices closely to determine if monetary expansion is viable. Since the PBOC is closely integrated with the politics of the Communist Party (the governor of the PBOC is appointed by the president of China), maintaining harmony in the Chinese society becomes a crucial objective for the PBOC. So to keep its society stable, the Chinese government needs a steady GDP growth to support migration from rural areas to cities and a low inflation rate. While the FED and the ECB can only control interest rates on the short end of the yield curve, the PBOC controls interest rates across all maturities. The PBOC can also change the Reserve Requirements Ratio (RRR), which is the amount of Yuan commercial banks must keep in their deposit accounts at the PBOC. The RRR can be increased for excess liquidity to be absorbed.

In the past decade, China ran a massive trade surplus. It exported more than it imported, which produced a steady flow of USD in the Chinese financial system. To keep the RMB pegged to the USD, the PBOC increased both the money supply and the RRR. These measures kept the RMB from rising against the USD and enabled the Chinese to export cheap goods.

SNB: the Swiss National Bank, along with the BoJ, is the other frequent player. Since the Swiss economy must export it's goods and services – but it does not export any raw materials- and it is surrounded by members of the Eurozone, it is of fundamental importance that the Swiss Franc (CHF) does not get too strong. So the SNB has always been happy to step in and propel EurChf and UsdChf higher when they get too low. There is a de-facto “peg” of the EurChf to 1.2000. This is not to say that the bank will not allow temporary deviations below that value – just that the lower EurChf goes, the more risk there is of a big intervention to push it back up. And if there is one thing that many currency traders have learned, it's that you do not want to fight a central bank. Do not expect it to be there for you when you need it most, and do not expect to be able to take aggressive bets against it. George Soros did not break the Bank of England alone. The SNB determines and interest rate band, not a target. It's mandate is to ensure price stability while taking into account the economic situation.

To sum up: central banks are the main players at the top of the food chain in the currency markets. Knowing how they reason, and what their tendencies are, can help you form your sentiment analysis in a more relevant way. Also, when you see giant candles on UsdJpy and EurChf, you know who to blame!

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