What Is a Central Bank?

A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Central banks are inherently non-market-based or even anti-competitive institutions. Although some are nationalized, many central banks are not government agencies, and so are often touted as being politically independent. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.

The critical feature of a central bank—distinguishing it from other banks—is its legal monopoly status, which gives it the privilege to issue banknotes and cash. Private commercial banks are only permitted to issue demand liabilities, such as checking deposits.

Understanding Central Banks

Although their responsibilities range widely, depending on their country, central banks’ duties (and the justification for their existence) usually fall into three areas.

First, central banks control and manipulate the national money supply. They influence the sentiment of markets as they issue currency and set interest rates on loans and bonds. Typically, central banks raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage monetary policy to guide the country’s economy and achieve economic goals, such as full employment.

Second, they regulate member banks through capital requirements, reserve requirements (which dictate how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees, among other tools. They also provide loans and services for a nation’s banks and its government and manage foreign exchange reserves.

Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even a government. By purchasing government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to increase revenue.

Example: The Federal Reserve

Along with the measures mentioned above, central banks have other actions at their disposal. In the U.S., for example, the central bank is the Federal Reserve System, aka “the Fed”. The Federal Reserve Board (FRB), the governing body of the Fed, can affect the national money supply by changing reserve requirements. When the requirement minimums fall, banks can lend more money, and the economy’s money supply climbs. In contrast, raising reserve requirements decreases the money supply. The Federal Reserve was established with the 1913 Federal Reserve Act.1

When the Fed lowers the discount rate that banks pay on short-term loans, it also increases liquidity. Lower rates increase the money supply, which in turn boosts economic activity. But decreasing interest rates can fuel inflation, so the Fed must be careful.

And the Fed can conduct open market operations to change the federal funds rate.2 The Fed buys government securities from securities dealers, supplying them with cash, thereby increasing the money supply. The Fed sells securities to move the cash into its pockets and out of the system.

A Brief History of Central Banks

The first prototypes for modern central banks were the Bank of England and the Swedish Riksbank, which date back to the 17^th century. The Bank of England was the first to acknowledge the role of lender of last resort. Other early central banks, notably Napoleon’s Bank of France and Germany’s Reichsbank, were established to finance expensive government military operations.

It was principally because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of United States’ founding fathers—most passionately Thomas Jefferson—opposed establishing such an entity in their new country. Despite these objections, the young country did have both official national banks and numerous state-chartered banks for the first decades of its existence, until a “free-banking period” was established between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single U.S. currency, with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907. In response, in 1913 the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations.1 The new Fed helped finance World War I and World War II by issuing Treasury bonds.

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. Consequently, monetary expansion could not occur simply from a political decision to print more money, so inflation was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country’s reserves of gold.

At the outbreak of World War I, the gold standard was abandoned, and it became apparent that, in times of crisis, governments facing budget deficits (because it costs money to wage war) and needing greater resources would order the printing of more money. As governments did so, they encountered inflation. After the war, 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 any political party or administration.

During the unsettling times of the Great Depression in the 1930s and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process. This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep control over all aspects of their countries—a backlash against colonialism.

The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macro-economy. Eventually, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the optimal way to achieve a liberal and stable economic regime.

Central Banks and Deflation

Over the past quarter-century, concerns about deflation have spiked after big financial crises. Japan has offered a sobering example. After its equities and real estate bubbles burst in 1989-90, causing the Nikkei index to lose one-third of its value within a year, deflation became entrenched.3 The Japanese economy, which had been one of the fastest-growing in the world from the 1960s to the 1980s, slowed dramatically. The ’90s became known as Japan’s Lost Decade.

The Great Recession of 2008-09 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions throughout the United States and Europe, exemplified by the collapse of Lehman Brothers in September 2008.

The Federal Reserve’s Approach

In response, in December 2008, the Federal Open Market Committee (FOMC), the Federal Reserve’s monetary policy body, turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases, aka quantitative easing (QE).

The former involved cutting the target federal funds rate essentially to zero and keeping it there at least through mid-2013.4 But it’s the other tool, quantitative easing, that has hogged the headlines and become synonymous with the Fed’s easy-money policies. QE essentially involves a central bank creating new money and using it to buy securities from the nation’s banks so as to pump liquidity into the economy and drive down long-term interest rates.5 In this case, it allowed the Fed to purchase riskier assets, including mortgage-backed securities and other non-government debt.

This ripples through to other interest rates across the economy and the broad decline in interest rates stimulate demand for loans from consumers and businesses. Banks are able to meet this higher demand for loans because of the funds they have received from the central bank in exchange for their securities holdings.

Other Deflation-Fighting Measures

In January 2015, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros’ worth of bonds, at a monthly pace of 60 billion euros, through to September 2016.6 The ECB launched its QE program six years after the Federal Reserve did so, in a bid to support the fragile recovery in Europe and ward off deflation, after its unprecedented move to cut the benchmark lending rate below 0% in late-2014 met with only limited success.7

While the ECB was the first major central bank to experiment with negative interest rates,8 a number of central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound.

Results of Deflation-Fighting Efforts

The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. Meanwhile, the concerted moves to fend off deflation globally have had some strange consequences:

• QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war.
• European bond yields have turned negative: More than a quarter of debt issued by European governments, or an estimated $1.5 trillion, currently has negative yields.9 This may be a result of the ECB’s bond-buying program, but it could also be signaling a sharp economic slowdown in the future.
• Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling balance sheets to record levels. Shrinking these central bank balance sheets may have negative consequences down the road.

In Japan and Europe, the central bank purchases included more than various non-government debt securities. These two banks actively engaged in direct purchases of corporate stock in order to prop up equity markets, making the BoJ the largest equity holder of a number of companies including Kikkoman,10 the largest soy-sauce producer in the country, indirectly via large positions in exchange-traded funds (ETFs).

Modern Central Bank Issues

Currently, the Federal Reserve, the European Central Bank, and other major central banks are under pressure to reduce the balance sheets that ballooned during their recessionary buying spree.

Unwinding, or tapering these enormous positions is likely to spook the market since a flood of supply is likely to keep demand at bay. Moreover, in some more illiquid markets, such as the MBS market, central banks became the single largest buyer. In the U.S., for example, with the Fed no longer purchasing and under pressure to sell, it is unclear if there are enough buyers at fair prices to take these assets off the Fed’s hands. The fear is that prices will then collapse in these markets, creating more widespread panic.

If mortgage bonds fall in value, the other implication is that the interest rates associated with these assets will rise, putting upward pressure on mortgage rates in the market and putting a damper on the long and slow housing recovery.

One strategy that can calm fears is for the central banks to let certain bonds mature and to refrain from buying new ones, rather than outright selling. But even with phasing out purchases, the resilience of markets is unclear, since central banks have been such large and consistent buyers for nearly a decade.