Introduction to Central Bank Policies

MN Trading
MN Trading
Published in
10 min readAug 17, 2023

After covering Macroeconomic Fundamentals and Economic Indicators in previous articles, I would like to dive a bit deeper into Central Bank Policies, what they aim at, and how it affects us as investors and traders. This, again, will consist of a number of articles, each diving deeper into certain aspects.

The policy set by central banks plays a crucial role in shaping movements within financial markets. To determine the future trajectory of the economy and its alignment with the bank’s policy objectives, central bank officials gather, analyze, and project economic data introduced in our Macroeconomic Fundamentals series, among others. Any discrepancies or challenges to the desired economic path can prompt central banks to take policy actions. However, formulating central bank policy involves more complexity than simply issuing press statements to announce changes in interest rates, adjustments in asset purchases, or other supportive measures. The execution of central bank policies also necessitates transactions within financial markets.

Central bank policies exert a direct and often immediate influence on foreign exchange (FX) markets, and extend to most risk assets including stocks and crypto. As central banks loosen or tighten their policies, the appeal of their respective currencies to hold may increase or decrease. Grasping the process by which central banks make these decisions is a valuable skill for traders, as predicting central bank actions enhances comprehension of significant economic data releases.

The Goal of the Federal Reserve Bank

While the US Federal Reserve garners the most attention and holds the utmost importance among central banks, its mandate extends beyond that of the average central bank. The Federal Reserve focuses on both achieving maximum employment and maintaining price stability, a broader scope compared to most central banks which emphasize only price stability. Price stability entails maintaining low, stable, and predictable inflation. Most central banks target an inflation rate of approximately 2%, seen as an indicator of robust and consistent economic growth. In the process of making monetary policy decisions, central banks evaluate a range of economic indicators, expectations, and prevailing conditions.

Economic Data

Central banks analyze the same economic data closely monitored by most traders and other market participants. Key data points such as unemployment, housing, and inflation are scrutinized by central bankers during their deliberations to shape and establish policies. These indicators are pivotal for understanding Gross Domestic Product (GDP) and identifying trends of expansion or contraction within a sizable economy. The ForexFactory Calendar is a valuable tool for traders to monitor the same data releases that central bankers closely observe.

Economists and Projections

In addition to tracking the economic data accessible to market participants, central banks employ teams of specialized economists. These economists possess expertise in specific areas and often hold positions of authority in their fields. They bear the responsibility of creating projections that central banks rely upon to formulate policies. By modeling future economic paths based on present data, future expectations, subject-specific knowledge, and potential policy options, economists offer insights that guide central bankers in anticipating the economy’s forthcoming direction and the possible repercussions of policy choices. Many central banks regularly release summaries of their economic and policy projections, serving as a valuable resource for traders aiming to grasp how a vital market influencer perceives the broader economic landscape.

Setting a Framework

Upon collecting the requisite economic data and projections, central banks apply them within a framework to determine the necessity for policy adjustments. This framework outlines the central bank’s comprehension of the correlation between key economic metrics and its mandate, often detailing how various economic data points impact inflation. The dynamic global economy has led to continuous evolution of central bank policy frameworks. Formerly, monetary policy relied on simple rules and equations that prescribed suitable interest rates based on the relationship between inflation and employment. Given the increased complexity of today’s world, central banks have moved away from this uncomplicated, rule-based approach to policy-making.

A significant and far-reaching development affecting central bank policy pertains to the enduring trend of low interest rates and inflation in developed economies. Prolonged low interest rates have reduced the central bank’s capacity to counter economic downturns solely through interest rate reductions. Moreover, persistently low inflation in the past, despite tight labor markets and low rates, has compelled central banks to revise and modernize their comprehension of the interplay between employment and inflation.

Considering these evolving dynamics, both the Federal Reserve and the European Central Bank (ECB) have conducted reviews of their monetary policy frameworks. The Federal Reserve disclosed its findings and new policy framework in the late summer of 2020. This announcement acknowledged the altered relationship between inflation and employment, indicating that the economy can withstand higher employment levels without triggering inflation concerns. Additionally, the Fed shifted its inflation policy from a symmetrical 2% target to an average 2% target, implying that the Federal Reserve will tolerate inflation exceeding 2% if it helps achieve a 2% average over time. Essentially, this new framework signaled to the market that the Fed would no longer rush to tighten policy at initial signs of overheating; instead, policy will remain accommodating and permit further economic expansion.

For traders and market participants, recognizing that elevated inflation readings and robust economic data would not automatically prompt the Fed to proactively tighten policy marked a significant departure from the post-financial crisis framework. In general, comprehending the central bank’s framework is of paramount importance for central bank observers and traders, as it enables more informed trading decisions by offering insights into market expectations following data releases. (Little did the market know that the Fed was about to enter its most aggressive global tightening in decades shortly after, showing that these projections and frameworks need constant monitoring renewal.)

Subsequent to aligning new economic data and projections with its framework, the central bank reaches a decision. While this choice was once as straightforward as adjusting interest rates up or down, central banks’ toolkits have expanded dramatically since the financial crisis, as they’ve taken on a more extensive role in bolstering the financial system and the overall economy.

Policy Tools

Before the financial crisis, the toolset employed by most central banks was relatively standardized. These banks would set short-term interest rates and regulate bank lending through reserve requirements and comparable metrics. The primary exception was the Bank of Japan, which ventured into unconventional policy tools starting in the 1990s at a time Japan was grappling with a substantial recession and deflation.

In the aftermath of the financial crisis, economies worldwide remained ensnared in a state of disruption. Led by the Federal Reserve, global central banks started adopting the unconventional policies pioneered by the Bank of Japan. These policies encompass substantial purchases of government bonds to inject liquidity into the financial system and maintaining policy rates at or near zero, including entering negative territory. During the crisis, central banks also deployed lending powers to devise new, targeted tools that could provide support to crucial segments of the financial system, such as money market funds and significant broker-dealers, which were beyond the purview of traditional central bank support mechanisms.

These unconventional tools have transformed into essential components of the central bank toolkit and have proven highly effective during the Covid crisis. In addition to slashing policy rates to the zero lower bound, central banks expanded the scope of their support measures to levels surpassing those witnessed during the financial crisis. They pledged support to corporate bond markets, backed vital financial system components, and engaged in trillions worth of government bond purchases.

Quantitative Easing

Subsequent to the financial crisis, central banks embarked on a journey to influence longer-term rates and infuse liquidity into the financial system, aiming to underpin economic spending, growth, and inflation. Through large-scale asset purchase initiatives, commonly referred to as quantitative easing (QE), central banks acquired substantial amounts of government debt from the open market. These operations are fundamentally similar to the conventional open market operations that central banks engaged in before the crisis, albeit on a significantly larger scale. Although the precise mechanism of how QE operates remains a subject of debate, these programs effectively drive down longer-term interest rates, bolster inflation, and frequently provide a favorable environment for other financial markets.

Notably, QE’s importance escalated due to the protracted era of low rates experienced by advanced economies. Since central banks could no longer solely rely on rate cuts to stimulate the economy during recessions, they turned to further QE initiatives. Research indicates that an asset purchase program equivalent to around 1.5% of GDP has a comparable impact to a 25 basis point rate cut. With US interest rates hovering around 1.50% prior to the Covid crisis, and rates even lower in other regions, ongoing QE programs served as a supplement to traditional rate cuts. Consequently, asset purchase programs expanded dramatically since the onset of the Covid crisis, leading to unprecedented growth in central bank balance sheets.

Source: Yardeni Research, August 16, 2023

Source: Yardeni Research, August 16, 2023

The execution of these unconventional support measures falls within the purview of the central bank’s Monetary Policy Implementation Division. This division oversees the practical application of central bank policy through trading operations and technical adjustments made within financial markets. Policy directives from senior central bank officials are transmitted to central bank traders, who then engage with specific counterparties to shift rates or execute policy decisions.

Setting Interest Rates

In the case of the Federal Reserve, monetary policy implementation is handled by the Federal Reserve Bank of New York. Before the financial crisis, decisions regarding the Federal Funds Rate were communicated to market desk traders. These traders conducted open market operations with primary dealers, i.e. major banks approved as trading partners by the New York Fed. Primary dealers were mandated to facilitate market-making and support the issuance of US Government debt (Treasuries). The New York Fed market desk would purchase or sell a specified quantity of Treasuries from these banks, altering the liquidity supply within the financial system and influencing short-term rates to align with the Federal Open Market Committee’s (FOMC) desired range. This fine-tuning of liquidity represented the approach employed by central banks worldwide before the unconventional tools of the financial crisis were introduced. However, the extensive injection of liquidity into global financial systems necessitated a more sophisticated policy-setting approach.

In the aftermath of the QE measures executed by central banks during the financial crisis, conventional open market operations no longer yielded a sufficient impact on liquidity and credit conditions to significantly alter interest rates. The primary policy tool for the Federal Reserve became interest on reserves; a rate at which banks accrue earnings for storing freshly-printed QE funds directly within the Fed.

Activity within the Federal Funds Market dramatically contracted as banks no longer needed to source funds to fulfill regulatory requirements, and interbank lending shifted to the repo market, where lending is backed by collateral. The New York Fed’s repo and reverse repo facilities emerged as crucial tools for managing the surplus liquidity within the system, with the rates on these facilities often adjusted in conjunction with the Fed’s principal policy rate. The repo (RP) facility enables the Fed to lend against Treasury collateral to participants in need of cash, thereby establishing an upper boundary for interest rates. Conversely, the reverse repo facility (RRP) operates in the reverse manner, with the Fed lending Treasury collateral to participants with excess cash. The RRP facility serves as a temporary mechanism to remove reserves from the system and establishes a lower boundary for interest rates.

Source: FRED

Between 2014 and 2018, the period preceding the Covid crisis and marking the apex of the Federal Reserve’s balance sheet, the RRP facility witnessed significant usage during quarter-end periods, as excess cash was siphoned from other areas within the financial system to prevent rates from falling below the FOMC’s lower target range. Given the heightened levels of bank reserves in the post-Covid landscape, similar substantial utilization of the RRP facility can be anticipated during future quarter-ends. In preparation for such utilization, the New York Fed raised the counterparty limit for the facility during the March 2021 FOMC meeting.

The implementation of QE initiatives follows a process akin to conventional open market operations. Traders within the central bank’s policy implementation division publish announcements and schedules outlining their purchasing plans. Counterparties present lists of bonds they are willing to sell to the central bank, and the central bank’s traders select and execute transactions with the most competitive bids. Contrary to popular memes depicting central bank-driven money printing, the digital money created by the central bank in exchange for these bonds is purely electronic. The accounts of transacting counterparties are credited with newly-generated digital currency from the central bank.

Forward Guidance and Communication

In light of the evolution of monetary policy implementation since the financial crisis, forward guidance has emerged as another crucial aspect of the central bank toolkit. Forward guidance entails the communication of future interest rate trajectories. The underlying principle of forward guidance is straightforward: businesses, investors, and markets are continually attempting to forecast the central bank’s forthcoming actions. By clearly communicating their intentions, central bankers can steer expectations toward their desired outcomes and provide greater clarity to markets. Forward guidance is closely aligned with the policy framework, integrating the central bank’s perspective on key metrics into their communication about future policy.

Effective communication, transparency, and the establishment of expectations have consistently evolved within central bank policy. Transparent policy assists the central bank in remaining both predictable and credible; both essential attributes for an institution wielding significant influence over the financial system. The FOMC began employing forward guidance in the aftermath of the financial crisis, signaling that rates would remain at zero “for some time.” As the recovery progressed, forward guidance terminology evolved from a time-based approach to a data-based approach and subsequently to an outcomes-based approach. Both iterations aid in establishing long-term policy expectations and have proven invaluable for central banks globally.

Central bank policy has undergone substantial transformation in the past two decades. While the data central banks utilize to shape policy remains relatively consistent, the execution of policy has undergone significant evolution. The emergence of enduring trends after the financial crisis has spurred the necessity for novel policy innovations. Central banks currently wield authority over rates and monetary policy through liquidity management, extensive asset acquisitions, technical refinements to money markets, and improved communication strategies. Grasping the interconnectedness of these elements, their mutual influence, and their implications for the broader financial markets holds substantial value for traders.

In the next article I will go further into Quantitative Easing and Tightening.

Written by: Gunter Lackmann