The job of a central banker, said William McChesney Martin, is to “take away the punch bowl just when the party gets going.” The legendary former Chairman of the Federal Reserve meant that it is up to the man or woman in charge of a country’s monetary policy—its interest rates—to ensure that the economy neither overheats nor sinks into depression.
When the economy is roaring ahead and businesses are making record profits, there is a danger of inflation getting out of hand, and it is the central bank’s unenviable task to try to bring the party to a civilized end, usually by raising interest rates. And if all goes wrong and the economy slumps, it is their job to prevent it suffering too nasty a hangover by cutting interest rates again. If that already sounds difficult, bear in mind that not even the central bank can know precisely how fast the economy is expanding at any given moment.
How central banks work The problem is that most of the statistics upon which central banks base their decisions are, by definition, out of date by the time they are published. Inflation figures—which are among the most promptly produced around the world—refer to the previous month. More fundamentally, because it takes time for the actual effects of certain changes in the economy to manifest themselves statistically (for instance, it takes weeks or even months for higher oil or metal prices to push up consumer prices), central banks have to drive the economy while looking out of the rearview mirror rather than the front window.
Almost every country with its own currency and a government able to impose taxes has a central bank, ranging from the Fed (as most people call the US central bank) and the Bank of England (which actually determines interest rates for all of the United Kingdom) to the highly respected Swiss National Bank and the innovative Reserve Bank of New Zealand. The European Central Bank sets interest rates for all countries in the European Union that use the euro.
Most central banks operate independently of politics, though their leading executives are usually appointed—or at the very least vetted—by politicians. To ensure there is a check on these unelected individuals, they are usually given a remit, which can be specific, as in the case of the UK and euro area (a Consumer Price Index inflation target of 2 percent) or more vague, as in the US (to entrench growth and prosperity).
How interest rates shape the economy Targets have changed over time. When, for instance, monetarism was in vogue in the 1980s, some central banks attempted to keep the growth in the money supply at a particular level. Nowadays, most central banks are more concerned with keeping inflation under control. Either way, the primary tool at a central bank’s disposal for influencing the economy is its interest rate.
Lower interest rates generally mean a faster-growing economy and potentially higher inflation as a consequence, since saving is less lucrative, and borrowing and spending are more attractive options. The situation is reversed with higher rates.
In general, most central banks set a base rate (this is called the Fed Funds Rate in the US and the Bank Rate in the UK) on which other private banks base their own interest rates. In order to set this rate, policymakers in central banks have various levers to pull. First, they announce that they are changing their rate, and private banks usually follow suit and change their own mortgage, lending and savings rates accordingly. Second, they use open-market operations, which means buying and selling government bonds in order to influence the interest rates throughout the bond markets (see Bond markets). Third, they capitalize on the fact that all commercial banks are obliged to store a slice of their own funds in the central bank’s vaults (these are known as reserves). Central banks can change the rate of interest they pay out on these reserves, or can order banks to hold more or less reserves, influencing how much they want to lend out to their customers, which in turn influences the interest rate.
The vast majority of these levers are invisible to consumers; what matters is the instant chain reaction they trigger, causing banks around the country to change the level of borrowing costs. The specifics of the levers only really matter when one or a number of them is broken, as can happen when money markets malfunction (see Money markets).
Although the banks tend to make an interest-rate decision every month or couple of months, they have hundreds of employees permanently at work monitoring actual rates of borrowing in the market to ensure that the medicine they prescribe is actually working. During the financial crisis of the late 2000s central banks around the world had to devise a number of novel ways to pump extra money into the economy.
Inflation isn’t the only thing affected by interest rates, however. Higher interest rates often strengthen a country’s currency as investors from around the world channel their funds into buying it. The downside of this is that a stronger currency makes a country’s exports more expensive for overseas customers.
“In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent, count greatly and results far much less.”
John Kenneth Galbraith
Supporting the financial system The role of central banks is not just to control interest rates but also, more broadly, to ensure that the underlying financial system of an economy is in good health.
As such, they also act as a lender of last resort in times of economic turbulence. When all is well in Wall Street and the City, for example, such a role is rarely necessary, since banks can generally borrow more cheaply and easily from their peers. At other times, however, the central bank’s emergency lending becomes an essential life-jacket.
One of the many repercussions of the 2008 financial crisis has been to force central banks to enhance their lender-of-last-resort role in order to rescue stricken banks. In a break with decades of convention, for instance, the Fed started lending cash directly to hedge funds because everyone—bar the government—was finding it almost impossible to borrow money. They also started to buy up assets and pump extra cash into the economy through a process called quantitative easing (see Debt and deflation).
However, as always in economics, there is no such thing as a free lunch—for consumers or for banks. This greater generosity has come at the cost of more stringent regulation in the future. Interest rates will continue to be a major policy tool for central banks, but their power to monitor and regulate the financial system is also very much in the ascendancy.
the condensed idea
Central banks steer economies away from booms and busts
| timeline | |
|---|---|
| 1668 | The Riksbank, the world’s first central bank, is founded in Sweden |
| 1694 | The Bank of England is founded |
| 1913 | The US Federal Reserve set up by Woodrow Wilson |
| 1998 | The European Central Bank established in preparation for the launch of the euro |