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What is a 'Central Bank'

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

The central bank of the United States is the Federal Reserve System, or “the Fed,” which Congress established with the 1913 Federal Reserve Act.

BREAKING DOWN 'Central Bank'

Central banks are inherently non-market-based or even anticompetitive institutions. Many central banks, including the Fed, 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 it legal monopoly status, which gives it the privilege to issue bank notes and cash. Privately owned commercial banks are only permitted to issue demand liabilities, such as checking deposits.

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 17th 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 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 U.S. did have both official national banks and numerous state-chartered banks, except for a “free-banking period” 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, the United States established the Federal Reserve System and established 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations.The new Fed helped finance World War I and World War II by purchasing Treasury bonds.

Functions of 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 money supply: issuing currency and setting 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 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 loan to customers, and how much capital 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.

How Do Central Banks Inject Money Into The Economy?

Along with the measures mentioned above, central banks have other actions at their disposal. In the U.S., for example, the Federal Reserve Board (the governing body of the Fed) can affect the national money supply by changing reserve requirements, the minimum amounts of cash that banks must hold in reserve against their deposits. When reserve requirements fall, banks can loan more money, and the economy’s money supply climbs. Raising reserve requirements decreases the money supply.

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. 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.

Central Banks and Deflation

What can central banks do to fight the pernicious and devastating effects of deflation, a sustained and broad decline in price levels in an economy over a period of time?

Over the past quarter-century, concerns about deflation have spiked after big financial crises and/or the bursting of stock market bubbles, such as the Asian crisis of 1997, the "tech wreck" of 2000-02, and the Great Recession of 2008-09. These concerns have assumed center stage in recent years because of Japan's experience after its asset bubble burst in 1990, causing the Nikkei index to lose one-third of its value within a year. As deflation became entrenched, the Japanese economy – which had been one of the fastest-growing in the world from the 1960s to the 1980s – slowed dramatically. Real GDP growth averaged only 1.1% annually from 1990 onward. In 2013, Japan's nominal GDP was about 6%  below its level in the mid-1990s. (For more on the Japanese economy, see From Mrs. Watanabe to Abenomics – the Yen's wild ride).

The Great Recession 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 – stocks, mortgage-backed securities (MBS), real estate, and commodities. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions in the United States and Europe, exemplified by the bankruptcy of Lehman Brothers in September 2008 (see Case Study – The Collapse of Lehman Brothers). There were widespread concerns that scores of banks and financial institutions that were on the verge of going under would do so in a domino effect, leading to a collapse of the financial system, a shattering of consumer confidence, and outright deflation.

The Federal Reserve's Approach to Deflation

In December 2008, the Federal Open Market Committee (FOMC, the Federal Reserve's monetary policy body) cut the target federal funds rate essentially to zero. The fed funds rate is the Federal Reserve's conventional instrument of monetary policy, but with that rate now at the "zero lower bound" – so called because nominal interest rates cannot go below zero – the Federal Reserve had to resort to unconventional monetary policies to ease credit conditions and stimulate the economy.

The Federal Reserve 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 Federal Reserve introduced explicit forward policy guidance in the August 2011 FOMC statement, in order to influence longer-term interest rates and financial market conditions. The Fed specifically said then that it expected economic conditions to warrant exceptionally low levels for the federal funds rate at least through mid-2103. This guidance led to a drop in Treasury yields, as investors grew comfortable that the Fed would hold off on raising rates for the next two years. The Fed subsequently extended its forward guidance twice in 2012, as a tepid recovery caused it to push out the horizon for keeping rates low.

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. 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 stimulates 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

Other central banks have also resorted to unconventional monetary policies to stimulate their economies and stave off deflation.

In December 2012, Japanese Prime Minister Shinzo Abe launched an ambitious policy framework to end deflation and revitalize the economy. Dubbed “Abenomics," the program has three main arrows or elements – (1) monetary easing, (2) flexible fiscal policy, and (3) structural reforms. In April 2013, the Bank of Japan announced a record QE program, saying it would buy Japanese government bonds and double the monetary base to 270 trillion yen by the end of 2014, with the objective of ending deflation and achieving inflation of 2% by 2015. The policy objective of slashing the fiscal deficit in half by 2015, from its 2010 level of 6.6 % of GDP, and achieving a surplus by 2020, commenced with an increase in Japan's sales tax to 8 % from April 2014, from 5 % earlier. The structural reforms element may be the hardest to get going, as it needs bold measures to offset the effects of an aging population, such as allowing foreign labor and employing women and older workers. 

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. 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.

While the ECB was the first major central bank to experiment with negative interest rates, 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 (see What is a currency war and how does it work?).
  • 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. This may be a result of the ECB's bond-buying program, but it could also be signaling a sharp economic slowdown in future.
  • Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling up  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 companies including Kikkoman, the largest soy-sauce producer in the country, indirectly via large positions in exchange traded funds (ETFs).

Central Banks' Contemporary Problems

Currently, the Federal Reserve, the European Central Bank (ECB), and other major central banks are under pressure to reduce the balance sheets that ballooned during their recessionary buying spree (the top 10 central banks have expanded their holdings by 265% over the past decade).

But doing so poses a risk of provoking another taper tantrum (a drastic increase in bond yields, due to panicked selling) of epic proportions. If major world banks in the U.S. Europe and Japan don't properly coordinate and execute the unwinding of some $13 trillion in assets built up since 2008, risk assets including stocks and mortgage-backed securities could sell off in a fire sale that would leave many investors – large and small – burned. In the worst-case scenario, the economic recovery, which is looking robust for the first time in a decade, might be at risk. (For more, see: What is the 'Taper Tantrum' and Why You Should Fear It.)

Unwinding Positions

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 a 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.

Before central banks begin the unwind, they will slowly reduce the amount of securities they are currently purchasing on the open market. In December 2016, the ECB said that bond purchases would be extended until at least the end of 2017, putting the total amount of assets purchased under QE at at least 2.28 trillion euros. Officials have said the monthly purchase amounts will be reduced gradually; at the April meeting, the ECB cut its monthly pace of purchases to 60 billion euros from 80 billion euros prior.

A Mature Strategy

One strategy that can calm fears is to allow certain bonds to mature and refrain from buying new ones, rather than outright selling. According to Bloomberg, "Fed officials’ current game plan is to start the balance-sheet run-down with a phasing out of reinvestment in maturing securities. The central bank will have $426 billion of its Treasuries mature in 2018 and another $357 billion in 2019."  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. In Japan, it is unclear how equity markets will react if the BoJ ceases ETF purchases. Bloomberg cites Japan's federal government pension plan as a potential receiver of these ETFs to fund its pension obligations as a "market-friendly solution," but only time will tell if this $13 trillion elephant in the room will fade away silently or make an undue ruckus.

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