The Financial System – The Central Bank
by elmads
INTRODUCTION
The financial system as a whole is a complex topic that only few people would like to understand. For some, The financial system as a whole is a complex topic that only few people would like to understand. For some, money itself is just a network of complicated theories and disciplines that makes life even harder to comprehend. To be honest, there is an element of truth about that, because even I didn’t like to even dabble with it at first.
Nevertheless, I still tried to understand it in a deeper sense because I know that money is an integral part of our lives. Don’t get me wrong with that statement, what I mean is that money is built on trust, which holds value as a means of exchange for products and services. What we want to achieve, either it be for experience, growth, material things, for helping others and whatnot, money is and will always still be needed for it.
Before we’re able to understand the basics of the financial system, we must first know a certain entity of every country that has a direct effect into it, and that is The Central Bank.
THE CENTRAL BANK
Most people think that a commercial bank is the same as the central bank, but they are not as there’s a monumental difference. Central banks are the Godfather of all commercial banks in a country. I’ll put emphasis on the word “in a country”, because most countries have their own central banks like, the Central Bank of England in the UK, The Federal Reserve Bank in the US, Bangko Sentral ng Pilipinas in the Philippines, and others more. There’s just this one exemption, and that’s the European Central Bank. They handle the money of not just one country, but various countries within Europe that utilizes “The Euro” currency.
For us to have a better grasp and understanding about central banks, we need to know first their purpose and what they do.
A Central Bank is a financial institution whose purpose is to oversee and control the quantity of money available in an economy and the channels by which new money is supplied. In short they are in charge of a country’s monetary policy. This just means that they make certain that the prices of goods and services within an economy is manageable, to keep inflation at bay, to stabilize their country’s currency and keep unemployment low.
Still too heavy to understand isn’t it? Let me make it more simple for you. Basically, Central Banks control the amount of money that flows in, out and just stays within the country they oversee, and make sure that the prices of products and services don’t go too hight nor too low.
Furthermore, central banks do not transact directly with people or businesses, they only transact with commercial banks. Whereas, commercial banks are the ones who do business and transaction with other banks, businesses and individuals in a country. Below is a photograph to clearly show their relationship.
To put the photo above into context, central banks only transact with commercial banks, while commercial banks both transact with Banks, Businesses, Individuals and also Governments.
Additionally, one of the purpose of Central Banks are to regulate Commercial Banks, to make sure that they have ample amount of liquid supply of money into their bank reserves and are not over leveraged.
Below is an infographic which I took from the Balance, regarding Central Banks.
With that basic definition and differentiation of commercial banks and central banks, we can now move forward. Into the ways of, how Central Banks control the monetary supply of a country and its economy.
MONETARY POLICY
Monetary Policy is all about the available money that is circulating in an economy. Central Banks are the only one who can produce and destroy their country’s currency. For Example; the US Federal Reserve is the only financial institution that can legally produce more United States Dollars, produce meaning print more of it. And, they are also the only one who can remove money that circulates within the economy, and they can also destroy it.
By controlling the Monetary Policy, they can in turn influence macroeconomic conditions of their country. Inflation rate, spending, employment rate and others more.
The Tools
Central banks have their own tools in their arsenal to calibrate the monetary supply and the economy.
1.) Interest Rates – This is the most popular way. Central Banks are also called “The Lender of Last Resort”. They can lend money directly to commercial banks, the rate in which commercial banks will repay the central banks are based on the federal funds interest rate that the central banks themselves regulate. For instance, a lower federal fund interest rate is for the sole purpose of enticing businesses and individuals to keep on borrowing money for spending, whereas an increase in interest rate is to reduce the borrowing hence the spending as well. Whatever will be the interest rate set by the central banks will have a direct effect in the deposit and loan interest rates that the commercial banks can offer to the public.
With regard to companies, a higher interest rate will mean higher interest payment on their existing debt. It will also discourage companies to borrow additional money. This in turn could impact some company’s profitability.
Basically, higher interest rates means less borrowing of money from banks, hence less spending in the economy. This is for the purpose to control a rising inflation. On the other hand, if the economy is slowing down, the central banks decreases the interest rate to spur spending within the economy. One example is during the COVID19 lockdown.
2.) Open Market Operation – This is how central banks directly impact the money supply within an economy. We have to focus on three factors in play here, which are Bonds, Money and the Transaction. Do you still remember what Bonds are? they are a debt security made by governments and/or corporations. Basically they’re borrowing money to the public, for a deeper understanding about this, see my blog titled “Bonds Asset Class”.
Going back to the Open Market Operations, Central banks have the power to produce or destroy cash, but for it to go in and out of the economy they then need to tap in the open market operations. Let’s start first with injecting money into the economy, for central banks to do this, they’ll need to buy governments bonds that the government has issued. So, the Government Bond Asset will now go to the central banks, while the cash they have will now go to the government.
This in turn will give liquidity for the government, which they can use for financing their country’s economic growth via building more roads, adding more jobs, subsidizing industries that they deem essential for their growth plans.
On the other hand, the newly acquired bond asset by the central bank will reflect on the their balance sheet, which is is usually available to be seen and accessed by the public.
Note: not all countries central bank is transparent with their balance sheet, unfortunately.
The above photo is the US Federal Reserve (US Central Bank)’s Balance sheet. It shows that, as of 2nd of March 2022, they’ve bought $8.9 Trillion worth of bonds in their balance sheet. This is also means that they’ve printed and injected $8.9 Trillion of money supply into the US economy.
The same process also happens when a Central Bank wants to reduce the money in the monetary system, they just need to sell the bonds they initially bought from the commercial banks, then the commercial banks do not have any other choice but to buy back the bonds and pay the money to the central bank in exchange. This will result to the decrease in the the Central Banks’ balance sheet and lower the amount of money supply in the economy.
Open market operations also affects the interest rate returns on bonds, commonly known as the bond yield, which I’ve also discussed in my blog the “Bonds Asset Class”.
3.) Commercial Bank’s Reserve Ratio – Central banks regulate their country’s commercial banks, included here are the money reserve ratio/percentage that the commercial banks must hold in their banking reserves. Let me give you a hypothetical examples, let’s say that Bank ABC has a required reserve ratio of 20% as dictated by the central bank, this means that they must have 20% liquid amount of money in their bank reserves. This is to make sure that if ever there will be any panic withdrawal of money from the people, the bank will have the liquid amount of to supply the withdrawal demand needed.
Increasing the Reserve Ratio equates to less lending of money by the commercial banks to the masses, whereas decreasing reserve ratio encourages banks to lend more money to the general public.
4.) Forward Guidance – This doesn’t include an actual change in interest rates or the money supply, instead it involves communication from the central bank to the people. It is just like companies who present their quarterly, half year and annual reports and telling their own projection of the business’ operations, investments, reinvestments and strategies moving forward.
This is what the Central Banks are doing as well, they give their future tactics or guidance to what can happen in the short to medium term economic outlook of the country where they are situated. They will also impart their plans which is dependent on the economic outlook. For instance, if they project that the inflation might go up than their average inflation rate benchmark, then they might need to decrease interest rates and also taper the open market operations, or if they see that there is still no good economic growth or output, then they might need to continue their current monetary policy.
This gives certainty to the people and the markets, to what they can expect that the central banks will do in the near to medium term future. This reduces the risk of panic as well within an economy, it’s the central banks giving assurance to the people. This can also help individuals to strategize how to handle money, like getting mortgage loans while the interest rates are at lower levels, or invest in commodities like gold if the inflation is expected to get higher than the expected average rate.
5.) Quantitative Easing – Both Forward Guidance and Quantitative Easing have been the central banks’ newest tool in their arsenal. Both tools where created during the global financial crisis. Quantitative Easing is simply the central banks printing a lot of money using their printing press.
The above photo has been a popular meme since the start of the covid19 global pandemic, in which the US Federal Reserve started printing billions to trillions of dollars of money for the past few years. The photo shows Jerome Powell (The US Federal Reserve Chairman during the time when the US went to covid19 pandemic induced recession) printing a lot of money using their high technological printing press that goes brrrrrrr (sound effects) haha! To be fair, it was the only option for the central banks to support the people of their country during that time.
In Quantitative Easing (QE), upon printing the large sum of money, the central banks will then inject that money via the open market operations. Remember that through Open Market Operations (OMO), where the central banks will only buy bonds issued by the governments? that’s changed now. Today, the US Federal Reserve can also purchase corporate bonds plus riskier assets such as mortgage backed securities and others more. These risker bond assets are commonly known in the bond market as junk Bonds. This is a topic of its own, but if you want to understand various classes of bonds, like the investment grade and non-investment grade bonds, see my blog titled “What is a credit rating?”
So basically, QE doesn’t just inject massive amounts of money in the system by buying safe government bonds with the help of their Open Market Operations, but it also buys poor rated junk bonds.
TO SUM IT UP
The central banks worldwide have evolved over time due to economic hardships and failures, as controversial as their newly created tools are, we still cannot disregard the fact that they are vital and important in controlling prices, monetary supply, and ultimately the economy.
Unfortunately, there were measures that they have taken before, which they cannot retract and change anymore. In a sense; the action has already been done, and they cannot rectify it anymore, what they can only do now is to prolong the health of the economy.
Knowing what the central banks do is imperative to know what actions we can take in order to protect and expand our hard earned money. At the end of the day, we cannot control the decisions that the central banks will make. What we can do is to shape our own perspective, mentality and strategy on how we will approach this information, and leverage it to our own benefit.
Knowledge is my Sword and Patience is my Shield,
elmads
This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.
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