Central Banks

Marjorie Olster

What is a central bank?

Central banks are among the most influential and closely watched financial authorities in virtually any country. Central banks were designed to act as lenders of last resort to prevent the collapse of the banking system in the event of a systemic banking crisis. The central bank typically controls a country’s money supply and interest rates and has the power to buy or sell domestic or foreign currency to affect exchange rates.

Central banks are usually made up of a board of directors or governors who have periodic meetings to discuss their country’s economic outlook and set monetary policy. The board members in the United States are appointed by the President and are accountable to Congress. They enjoy a degree of independence from political considerations such as what policies are popular with the electorate.

The inner workings of most central banks are shrouded in secrecy; the policy-making meetings are closed to the press. In the United States, high-ranking members of the central bank rarely give press interviews.

The central bank has a large research staff which investigates current topics in the economy and monetary policy and sometimes does historical analysis. Their reports are closely followed and carry great weight in the economic community and often make terrific analytic stories for a central bank reporter. Try to follow the central bank’s research as closely as possible and line up interviews with research economists on their areas of expertise.

Many central bank research departments put out periodic forecasts on major economic indicators. These are important stories because a forecast can also be seen as a target and can indicate what the central bank sees as the most desirable levels for inflation, growth and employment.

A central bank reporter should closely follow the statements and speeches of key central bank officials for any hints on the direction of policy or assessments of the economy. Whenever possible, try to obtain exclusive interviews with officials or economists at the central bank to learn more about the inner workings of this powerful institution.

What are the central bank’s mandates or objectives?

The central bank sets monetary policy aimed at controlling inflation by keeping interest rates and/or the money supply (currency in circulation plus deposits) at a targeted level. The target level is the level at which the central bank believes supply and demand in the economy will be in relative balance.

In many countries there are laws that set out a central bank’s objectives or mandates. Some countries have an inflation rule which mandates that the level of inflation must not rise above a certain percentage point. In the United States, the Federal Reserve has a much debated dual mandate which calls for maintaining low and stable inflation while promoting maximum sustainable growth and employment. There is no specific inflation target. But many other central banks have just a single mandate of keeping inflation low.

Economists have determined that if demand for goods and services exceeds the supply, it eventually drives up prices and risks creating instability that will hurt the public’s confidence in the monetary system. Inflation in small amounts is not damaging but high inflation erodes the value of savings and can affect the behavior of consumers, businesses and investors.

What tools do central banks use to control inflation or stimulate growth?

What tools does the central bank have at its disposal to steer the economy? Does the central bank you are covering have an inflation rule which mandates a targeted level for price rises? A central bank can control any number of policy levers including interest rates, money supply, foreign exchange sales and the reserve ratio or the percentage of checking deposits banks are required to hold on reserve.

The most prevalent tool used by central banking today in setting monetary policy is interest rates. In the 1980s, the US central bank targeted a rate of growth in the money supply. But later it decided there wasn’t a strong enough correlation between money supply growth on the one hand and economic growth and inflation on the other. So it switched to targeting interest rates.

Raising interest rates increases the costs of borrowing for consumers and businesses and tends to curb demand and eventually drive down rising inflation or keep inflation from rising further. If supply exceeds demand, producers can lose the power to raise prices or maintain profitable prices for their goods, causing deflation which can devastate an economy. Lowering interest rates can encourage consumers and businesses to borrow money which they then invest in items like homes, computers or office furniture, stimulating demand and growth in the economy.

The central bank sets the overnight bank lending rate -- the rate banks charge each other to borrow money for one night. That rate does not directly affect the rate of borrowing for consumers or businesses but it serves as a benchmark or a standard that affects borrowing costs throughout the economy. Other rates normally follow the direction of the overnight lending rate. For example, after a central bank rate hike, credit card rates and mortgage rates normally rise too even though the central bank does not directly affect those rates.

There are other theories or rules that economists and central bankers use to guide and understand monetary policy. One rule popular in the late 1990s in the United States was known as the NAIRU (Non-Accelerating Inflation Rate of Unemployment) and held that if unemployment fell below 6 percent, inflation would accelerate. Another theorem known as the Taylor Rule is often cited in the United States as a guideline for how the central bank should set the key overnight federal-funds rate. The Taylor Rule says the correct level for the real, inflation-adjusted fed-funds rate should be based on the relationship between growth and inflation levels or, in other words, whether inflation is above or below some target and the gap between actual and potential growth in the economy.

The Taylor Rule states that interest rates should fall by half a percentage point for every percentage point decline in economic growth, below the level of growth the Fed deems non-inflationary

Some key issues in covering central banks

Interest rate predictions are the bread and butter of any central bank-watching journalist. The direction, timing and magnitude of interest rate changes are of keen interest to domestic and foreign markets and investors. Many news services poll an elite group of senior economists regularly to get a consensus view on interest rate predictions and then write stories and analyses of the poll findings. These experts are usually pretty adept as a group at predicting upcoming changes. Another place to look for signals on the direction of rates is at long-term bond market rates. If traders are expecting inflation to rise, they often drive up rates on longer-term government and corporate bonds to reflect the increased risk of inflation over time. This can give a sense of where shorter-term interest rates set by the central bank might be headed.

One key question to ask when covering a central bank is does the central bank have credibility with the markets and the public? Do they believe in the central bank’s resolve to fight inflation? If not, it can be reflected in the market pricing. For example, government and corporate bond market rates which are determined by market participants do not always follow in lockstep with central bank rates. If the markets believe the central bank is not doing a good job at fighting inflation, they might drive up rates for long-term debt securities to reflect the increased risk of inflation in the future. This in turn can put pressure on the central bank to raise rates to restore its credibility with the markets. The central bank may want to keep interest rate expectations in the market under control by showing it is pro-active in keeping inflation low.

Tips for interest rate predictions: To predict trends in interest rates or understand the predictions of experts, it is important to know which economic indicators the central bank is looking at when it makes its decisions on raising or lowering rates.

  • The first place to look is at inflation indicators. Measures of current inflation are helpful but perhaps more important are inflation forecasts for the future. That is because economists believe changes in interest rates affect the macro-economy with a lag of months or even a year. So in making a decision on rate changes, the central bank needs to have an idea of where inflation is headed, as well as what it did in prior months.
  • Central banks will also look at measures of growth, production and consumer confidence in making monetary policy decisions, especially those indicators or components of indicators that have some predictive power for the future. For example, former Federal Reserve chairman Alan Greenspan liked to look at an indicator called supplier delivery times, which is one component of a monthly manufacturing report, to see whether bottlenecks are developing in the supply chain. If delivery times slow, it could be a sign that demand is outpacing production and supply and interest rates need to rise to achieve a better balance. So try to find out what the central bank you are covering is looking at. It isn’t always easy, because central banks can be secretive about their decision-making process.
  • Knowing your central bank and its priorities is key. For instance, in Vietnam, like the United States, the central bank also focuses on economic growth. Economists there often worry that falling inflation is a sign that growth is slowing and the central bank is less likely to raise interest rates to forestall a rise in inflation.

Transparency: The story of how a central bank makes its decisions can also be an interesting one, if you can find out. How transparent is that decision making process? Do the central bank officials give clear signals to the markets on what they are planning to do to minimize the element of surprise? Sometimes the central bank may want to surprise the markets so that its move has a bigger impact. These are all questions worth asking.

In the United States, there has been a gradual movement towards greater transparency at the Federal Reserve Bank over the past decade. The Fed only began announcing specific changes in target interest rates in 1994. Before that, it only signaled changes through daily money market operations.

In the late 1990s, the Fed began making statements after each policy meeting on where it saw the balance of risks in the economy, either tilting towards higher inflation i.e. higher interest rates or towards risk of recession i.e. lower interest rates or an even balance between the risks. The statements were meant to signal markets as to the likely direction of future interest rates. Not everyone was happy with the change. Some complained that the complicated phrasing of the balance of risk statements were even more confusing than having no statement at all. The Fed has continued to try to refine the process.

The Fed has also started to release minutes of the meetings but with a lag of more than a month. Some would like to see the minute released in a more timely fashion.

Central bank independence is always an interesting topic for journalists. What degree of independence does the central bank have from the political authorities? Who has the power to appoint central bankers and who are they accountable to? Is there ever political pressure on the central bank to act in a way which perhaps is not consistent with its mandate of maintaining low and stable inflation? For example, let’s say it’s an election year, unemployment is up and the party in power would very much like to see interest rates lowered to spur the economy on. But the central bank has forecasts showing the economy is poised to pick up and inflation expectations are rising. A decision by the central bank not to lower rates further could be unpopular with the political powers but would show a commitment to an inflation-fighting mandate. Studies have shown a correlation between high degrees of central bank independence and low inflation.

The central bank is not monolithic; its board is made up of members with sometimes widely varying points of view on the economy and on how to set monetary policy. In the United States, journalists who cover the central bank try to identify the “hawks” – those bankers who want to be aggressive about fighting inflation, even at the cost of slower growth – versus the “doves” who favor a slightly looser monetary policy in favor of faster growth and greater employment. The composition of the board can influence the direction of policy and should not be overlooked.

These are just a few examples of topics worthy of journalistic exploration.

How effective are interest rate changes?

Things don’t always work according to the textbook theories of monetary policy. In Japan in 1999 the central bank effectively lowered interest rates to zero but fiscally conservative Japanese consumers continued to save money at very high rates and spend conservatively.

A number of South American countries suffered from hyperinflation in the 1980s and could not control it by raising interest rates. A few took the drastic step of “dollarization” or pegging their currencies one-to-one to the U.S. dollar to get inflation under control. In doing so, they essentially gave up the autonomy of their central banks to control monetary policy.

Crisis Management: A crisis can throw even the well-guided monetary policy off course. The central bank is often called the lender of last resort which means that in a crisis such as a large bank failure or a credit crunch the central bank steps in to assure that there is no systemic threat that could paralyze the entire financial system of the country. How does this work? In the first trading session after the U.S. stock market crash of 1987 and the Sept. 11 2001 attack on the World Trade Center, the U.S. central bank cut interest rates. It was an instant reaction to a major financial or political crisis intended to shore up public confidence in the stability of the banking system. The Fed issued similar statements on both occasions assuring the financial markets that it stood ready to provide as much liquidity as needed to banks to get through the crisis. This was reassurance in effect that the Fed would provide all the money and credit needed to smooth out the bumps and help the banks weather the storm. The tactic was considered successful in both cases.

The Fed did the same with the financial crisis that began in early 2007 with defaults on home loans to borrowers with poor records, known as “subprime” mortgages. As one bank after another reported massive write-downs, the Fed aggressively cut rates – in one case by as much as three-quarters of a point (it usually moves in quarter points at a time). It did this to try to stop the credit crunch from choking off the “real” economy – businesses and consumers in the US and the rest of the world. The Fed also “pumped liquidity” into the money markets and eventually had to step in and take control of the country’s two biggest home loans institutions. It was also at the center of decisions about which big investment banks should be allowed to fail and which had to be “rescued” as the crisis grew into the biggest financial and economic convulsion since the 1930s.

In 1998, Russia defaulted on its debt payments in the wake of a serious currency crisis in Asia. The U.S. stock market fell sharply in response and investors became very risk averse. This made it difficult for anyone except for the highest rated companies to get credit in the private debt markets, resulting in a credit crunch. The Fed recognized that the trend could do serious damage to the economy and so it cut rates three times in quick succession in the fall of 1998. It worked and credit eased up, though investors took a long time to recover their pre-August-1998 appetite for risk.

Very infrequently, in a crisis the central banks of the world’s biggest economies will act together to make concerted interest rate cuts if there is a major global financial crisis. A year after the outbreak of the Asian financial crisis, in December 1998, 12 European Union countries cut their rates. In the weeks prior, countries around the world cut their rates too. Even if there is no crisis, central banks in countries that are closely linked economically may adjust their rates at the same time. Before the European Central Bank was founded, the Netherlands and other European central banks adjusted their rates when the German central bank changed theirs. In the subprime credit crisis, the ECB was at first more cautious than the Fed, preferring to keep its eye on inflation rather than threats to economic growth. The severity of the crisis intensified debate about the role of central banks in paying attention not just to consumer prices but asset prices as well.

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