A central bank is an institution that regulates its interest rates and manages the money supply for the economy of the country under its purview or for a group of them, as is the case in Europe. In other words, since it is the only entity capable of printing money, it controls the money in circulation.
They tend to be institutions highly independent of any political affiliation, or at least they should be, to better perform their function with suitability and in an impartial manner.
What does a Central Bank do
In short, its main objective is price stability by controlling inflation to prevent extreme rises in the price of goods. Some central banks, such as the US Federal Reserve, may have objectives of a different nature, as we see in the case of the Federal Reserve, which has a certain percentage of unemployment as its target.
To enforce their monetary policies they use a few tools, the three main ones being:
- Management reserve requirement – Central banks are able to control the minimum amount of money that member banks need to hold in reserve. If they increase the reserve requirement, banks have less money available to lend, which can cause an economic slowdown and inflation. Decreasing the requirement will cause the opposite to happen.
- Interest rate management – The second most used tool is the central bank interest rate, the rate that is charged to the commercial banks used by all of us. This change in the central interest rate ultimately influences other rates in various economic activities such as interest on loans, interest received on a deposit, or even the interest rate on bonds.
- QE/Qualitative Easing – The third tool we mentioned is the previously mentioned QE, used as a last resort. Basically, the central bank buys financial securities from member banks and in doing so injects money into the economy to stimulate growth in case the central bank has an expansionary policy.
These tools are used to follow the monetary policy put in place by the central bank.
As we said earlier the objective of central banks is to achieve price stability by controlling inflation. Thus, to describe the position of central banks on inflation we can have two positions: hawkish, an adjective derived from hawk in English, and dovish, derived from dove in English.
These two terms are used to refer to two different views of how monetary policy should influence the economy.
- Hawkish – The term hawkish is used to describe a monetary policy with a greater focus on controlling rising inflation, with more austerity. In order to avoid a sharp rise in commodity prices and controlled wages, if the current central bank stance comes across as hawkish, there will be a greater tendency to raise interest rates and limit money in circulation to slow economic growth and avoid currency devaluation. This will undoubtedly be detrimental to job creation and new investment, but for those on a fixed and stable income, it is reasonably beneficial since their purchasing power will not decline.
- Dovish – On the other side there is the dovish stance, which presents an expansionary monetary policy. They do this by lowering the interest rate and increasing the amount of money in circulation. Thanks to this decrease in the cost of borrowing motivate new investment or expansion of existing businesses, thus creating jobs and investment, but with the consequence of possibly increasing inflation and fostering price increases.
The President or the executive committee headed by its Chairman who is in the power of the central banks can vary their position depending on the economic cycles.
The setting of these policies and the decision-making in this central body influences the intentions of investors around the world. It is easy to understand the importance that should be given to the public statements of its representatives.
Visit the Disclaimer for more information.