What Do Central Banks Do?

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Why Interest Rates Matter to FX

Interest rates are so vital to the working of an economy that in most countries, this responsibility is given to the central bank.  The central bank hopefully acts independently and without a political motive. What does it mean when the central bank sets the interest rate and how does this affect a currency?

This is how interest rates work
This is how interest rates work © forexop

The goals of a central bank are: To control inflation, to keep the economy healthy and stable, and in some cases, managing the foreign exchange rate.

In most countries the official bank rate, the one that is set by the central bank, refers to what’s called the overnight lending rate.

This is a target interest rate for short-term funding. In setting this rate, the central bank influences the basic cost of money in the wider economy.

This rate ripples through to everything from bonds and mortgages to credit cards.

The central bank’s communication with the markets is by far the most powerful tool it has.

Keep in mind that central banks influence rates – they can’t enforce them. While a central bank can set a target interest rate for their currency, market forces will decide the actual rates lenders and borrowers will use in a free and open market. The target rate and the market rate can be different, especially in the case of a distressed economy.

Although they cannot enforce an interest rate, central banks have some pretty powerful levers that they can pull:

  • Controlling the amount of money in circulation
  • Buying and selling securities in the open market to alter money supply
  • Adjusting the bank rate – the interest rate at which banks can borrow from the central bank.
  • Setting the rates on the compulsory reserves balances that banks and lending organizations have to deposit with the central bank
  • In the U.S. the Federal Reserve sets the rate at which banks can lend and borrow with each other against their reserve balance. This is the fed funds rate.

The above measures strongly influence the real rates at which banks can lend and borrow on a daily basis. This means an official interest rate change will cascade through the market. With the above tools at their disposal, the central banks have considerable powers. This is why for most major currencies, the policy statement itself is enough to price rates into the market before the measure even take effect. In this way, the central bank’s communication with the markets is by far the most powerful tool.

When lowering interest rates is not enough, central banks may use other methods like quantitative easing.

What happens when central banks lower interest rates close to zero and it still isn’t enough to speed up the economy? When lowering interest rates is not enough, central banks may use other methods like quantitative easing. Quantitative easing, or QE is simply a way that the central bank tries to lower interest rates by intervening directly in the market. This is usually done by buying government debt.

Asset purchasing programs pump money into the financial system and so make money cheaper and more plentiful. In other words, it lowers yields (the cost to borrowers) and adds liquidity (buyers) to markets and the banking system as a whole.

Just like printing money, it stimulates the economy but eventually it devalues a currency. It also devalues debt owed to foreign creditors and so can be used to reduce trade deficits and sovereign debt.

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