Central Banks, Their Functions and Role
BY
KIMBERLY AMADEO
REVIEWED BY
MICHAEL J BOYLE
on June 30, 2020
A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services including economic research. Its goals are to stabilize the nation's currency, keep unemployment low, and prevent inflation.
Most central banks are governed by a board consisting of its member banks. The country's chief elected official appoints the director. The national legislative body approves him or her. That keeps the central bank aligned with the nation's long-term policy goals. At the same time, it's free of political influence in its day-to-day operations.
The Bank of England first established that model. Conspiracy theories to the contrary, that's also who owns the U.S. Federal Reserve.1
Monetary Policy
Central banks affect economic growth by controlling the liquidity in the financial system. They have three
monetary policy tools to achieve this goal.
First, they set a reserve requirement. It's the amount of cash that member banks must have on hand each night.2 The central bank uses it to control how much banks can lend.
Second, they use
open market operations to buy and sell securities from member banks. It changes the amount of cash on hand without changing the reserve requirement. They used this tool during the 2008 financial crisis. Banks bought government bonds and mortgage-backed securities to stabilize the banking system. The Federal Reserve added $4 trillion to its balance sheet with
quantitative easing.3It began reducing this stockpile in October 2017.
Third, they set targets on interest rates they charge their member banks. That guides rates for loans, mortgages, and bonds. Raising interest rates slows growth, preventing inflation. That's known as contractionary monetary policy. Lowering rates stimulates growth, preventing or shortening a recession. That's called
expansionary monetary policy. The European Central Bank lowered rates so far that they became negative.4
Monetary policy is tricky. It takes about six months for the effects to trickle through the economy. Banks can misread economic data as the Fed did in 2006. It thought the subprime mortgage meltdown would only affect housing. It waited to lower the
fed funds rate. By the time the Fed lowered rates, it was already too late.5
But if central banks stimulate the economy too much, they can trigger inflation.6 Central banks avoid inflation like the plague. Ongoing inflation destroys any benefits of growth. It raises prices for consumers, increases costs for businesses, and eats up any profits. Central banks must work hard to keep interest rates high enough to prevent it.
Politicians and sometimes the general public are suspicious of central banks. That's because they usually operate independently of elected officials. They often are unpopular in their attempt to heal the economy. For example, Federal Reserve Chairman Paul Volcker (served from 1979-1987) sent interest rates skyrocketing.7 It was the only cure to runaway inflation. Critics lambasted him. Central bank actions are often poorly understood, raising the level of suspicion.
Bank Regulation
Central banks regulate their members.8They require enough reserves to cover potential loan losses. They are responsible for ensuring financial stability and protecting depositors' funds.
In 2010, the Dodd-Frank Wall Street Reform Act gave more regulatory authority to the Fed. It created the Consumer Financial Protection Agency. That gave regulators the power to split up large banks, so they don't become "too big to fail." It eliminates loopholes for hedge funds and mortgage brokers. The Volcker Rule prohibits banks from owning hedge funds. It bans them from using investors' money to buy risky derivatives for their own profit.9
Dodd-Frank also established the Financial Stability Oversight Council.10 It warns of risks that affect the entire financial industry. It can also recommend that the Federal Reserve regulate any non-bank financial firms.
Dodd Franks keeps banks, insurance companies, and hedge funds from becoming too big to fail.
Provide Financial Services
Central banks serve as the bank for private banks and the nation's government. They process checks and lend money to their members.
Central banks store currency in their
foreign exchange reserves. They use these reserves to change exchange rates. They add foreign currency, usually the dollar or euro, to keep their own currency in alignment.11
That's called a
peg, and it helps exporters keep their prices competitive.
Central banks also regulate exchange rates as a way to control inflation. They buy and sell large quantities of foreign currency to affect supply and demand.12
Most central banks produce regular economic statistics to guide fiscal policy decisions. Here are examples of reports provided by the Federal Reserve:
- Beige Book: A monthly economic status report from regional Federal Reserve banks.
- Monetary Policy Report: A semiannual report to Congress on the national economy
- Credit Card Debt: A monthly report on consumer credit.
History
Sweden created the world's first central bank, the Riksbank, in 1668. The Bank of England came next in 1694. Napoleon created the Banquet de France in 1800. Congress established the Federal Reserve in 1913.13 The Bank of Canada began in 1935,14 and the German Bundesbank was reestablished after World War II. In 1998, the European Central Bank replaced all the eurozone's central banks.
