The Bank of England.

The European Central Bank.

The Federal Reserve.

The Bank of Japan.

You've probably heard of one of these if you have had the slightest bit of interest in financial news over the past ten years.

The image that you might conjure up in your head is of men in suits, sitting around doing boring stuff.

Here are the two images that I get in my head.

One is from the Hunger Games Part 2, and the other is of the ECB Governing Council's breakfast meeting.

Can you guess which one is which?

The quote I like to attribute to both pictures is

'Let them eat cake.'

Much like the post-Great Financial Crisis world, The Hunger Games is about a post-apocalyptic future dystopia where districts fight to the death to maintain control.

'David tell us how you really feel.'

I'll get off my objective high horse now and give you an explainer as to what central banks do.

What do central banks do?

To put it simply, central banks control the money supply in an economy.

In the case of the European Central Bank, they control the money supply of the Eurozone economy, which is made up of 19 countries.

Many people simply don't know what they do, and they don't know what they do because it is pretty boring, unless you're perhaps involved in financial markets.

It can be quite complex.

Their role is vitally important, since their goals have varying influences on the economy, and your pocket.

They tend to have three main objectives:

  • Price stability

  • Full employment

  • Prevent inflation (and deflation)

Price stability relates to the extent to which a currency appreciates or depreciates, and is closely linked to their latter goal as well.

If a currency decreases heavily relative to another currency, then it can have inflationary effects.

On the other hand, if it appreciates heavily, it can lead to deflationary effects in an economy.

Why is that?

Part of this is due to something known as aggregate demand.

Here's the maths behind that.

AD = consumption + investment + government spending + (exports - imports)

If a currency appreciation makes importing cheaper, then aggregate demand could decrease is a factor to consider here (and conversely if the currency depreciates).

Central banks don't specifically try to target the currency price, but they do indeed target the CPI measure of inflation, which has many drawbacks in my view.

Central bankers look at the CPI measure as a barometer of price stability, yet disregard asset prices which arguable have a worse distributive effect on people's expenditure - house prices under a low rate environment shoot through the roof for example.

Why?


If the rate of interest is decreasing, you end up paying less to borrow.

Central bankers believe that to stimulate an economy during a downturn, the right policy shift is to reduce interest rates and to increase the liquidity in the economy by allowing credit to flow easier.

This is done through something known as quantitative easing, one tool in their open market operations that they can utilise to try to get the economy going again.

I have described the issues with quantitative easing in this piece below.

Inflation won’t be caused by money printing alone
One of the narratives flying about as to why gold is on a tear is because ofhedging against inflation. Over the years, gold has been seen as a price stability mechanism; a tangibleway to counteract the inflatory policies of central banks... It predominantly has this tag because it’s priced in do…

By increasing or decreasing the amount of credit in an economy, they believe they are able to influence CPI inflation - an increase or decrease in the price level based on a basket of goods.

The piece linked above would explain why there are issues with this premise.

Central bankers work on the premise that inflation should be kept in a target range of 1-3% (formally measured at +/- 2%).

But when a measure becomes a target, it ceases to become a good measure!

Let's take a look at what central bankers are probably looking at to explain their decisions to lower rates.

This is a supply and demand diagram showing the relationship between economic goods and liquidity preferences.

IS = Interest-savings

LM = loanable funds market

As there is an increase in the money supply (LM shifts outwards), it is assumed that interest rates will fall and national income will increase.

Whilst this may be true, there comes a time when doing this will create issues.

As we approach zero percent on the nominal rate (otherwise known as the zero lower bound), we find that central banks run out of options.

They then are forced to turn to using greater powers (such as quantitative easing) since consumers enter what is known as the liquidity trap.

This is where low interest rates mean that people hoard cash as savings, rather than purchasing bonds, based on the belief that interest rates will rise soon.

We can look to the personal savings rate of Japan to see this in action.

Japan's interest rate has been negative since 2016, whilst their inflation rate has also remained stagnant.

This comes even though the Bank of Japan have expanded the money supply dramatically and used even more unconventional methods than other central banks to attempt to increase inflation to be able to increase the rate of interest and see some normality.

An example of their more than unconventional methods of increasing LM is by buying domestic exchange traded funds, of which they are now the largest owner of at over 80%.

Something else that central banks do not factor in is how the consumer will respond to an increase in asset prices through borrowing being made 'cheaper'.

If the cost of buying a house or renting increases, then consumers will be able to spend less in the economy, keeping a cap on CPI inflation.

Here's why low interest rates are bad

With this comes another issue, and that is that low interest rates lead to low productivity.

I shall quote what I have written in this piece.

Since low rates (and negative real rates especially) are so easy to obtain, especially in Europe, we have a situation where you're just feeding something that should really be dead.
In Europe, firms are less likely to go to capital markets for funding versus the US.
Instead, they go to banks.
And banks make money from loans.
If they can provide loans to firms that can repay, who cares if those firms aren't actually able to improve?
The banks make money.
The problem is that wages don't increase - there is likely little net benefit to the wider economy other than staving off the inevitable, such as when a tail risk event like the response to the Corona virus happens.
S&P sees European corporate default rates spiking to 8.5% from 3.5% in the back end of this year...
Alexandra Dimitrijevic, S&P’s Global Head of Research, said that with the number of firms on downgrade warnings at record levels -- 37% of the companies S&P rates and 30% of the banks -- and credit quality dropping, default rates are set to jump.
“One third of speculative-grade companies are rated B- or below in Europe, which is up 10 percentage points compared to before the (COVID) crisis. So that is why we expect the default rate to effectively double”.

Low rates lead to an adverse selection of who should really receive capital.

And this creates a certain doom loop whereby rubbish firms stay alive, not allowing the capital to flow to the innovative firms that can promote growth.

Let's get back to what central banks do...


Let's use the example of the Federal Reserve, since they are the most important central bank globally.

How do they actually come up with their decisions?

There are twelve voting members, seven from the Board of Governors of the Federal Reserve System and five from the other Federal Reserve banks.

The President of the Federal Reserve Bank of New York always has a seat, whilst the remaining four voting members have one President who rotates in each group (there are four groups) for one year each.

The groups are Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco.

These are the current committee members.

By law, the FOMC must meet at least four times per year, but it has been more frequent in the post-Great Financial Crisis world, with meetings occurring roughly double that as monetary policy has had to be more closely monitored and adjusted.

The voting members propose their forecasts to each other and essentially decide on where to set the Federal Funds rate, a target range of interest that banks charge one another for short term loans.

Once the decision is agreed upon (some members may dissent, but for a policy to go through, there simply has to be a majority), they then send the instruction to the New York Fed's desk to conduct the agreed upon Open Market Operation which involves the buying and selling of securities to achieve the desired goal.

Now, the Fed operates a dual mandate.

These are price stability and maximum unemployment (as described above - but they tend not to explicitly intervene in the FX market as much as other central banks).

Following off of this dual mandate are other longer term goals.

👉 Here is the Fed's revised statement on their longer term strategy 👈

This statement is quite key.

The Committee seeks to explain its monetary policy decisions to the public as clearly as possible.

I don't think that's true, otherwise I wouldn't be writing this article!

Here's a Twitter thread we wrote, critiquing the belief from central bankers that their actions are understood by the public.

The mechanism which they feel is well understood by the public is most definitely not understood by the public.

How do central banks increase money supply?


Above, we mentioned that the New York Fed's desk undertakes Open Market Operations.

What does that mean?

Well, to increase the money supply, there has to be a mechanism by which the Fed can place the money they create into the economy, right?

They do this by purchasing Treasuries from primary dealers (commercial banks) which provides them with liquidity to then create loans and conduct business according to the demands of the consumer.

Excess cash can also then be put to use.

They do this until the desired Fed Funds target range is achieved.

The problem is that this mechanism tends to create a stickiness in financial assets, rather than feeding down into the real economy...

'Stocks only go up' is born through this.

The New York Fed's trading desk can also do the opposite.

To send the Fed Funds rate higher, they sell Treasuries on the Open Market to reduce liquidity.

Since the Fed Funds range is the benchmark interest rate, this affects every other borrowing and lending rate out there, which is why it is such an important measure when looking at financial markets.

And since the dollar rules king (we explained the importance of USD in the below article), analysis and trade ideas tend to start with the Fed and the US dollar.

The Importance of Being the Dollar
Why is the dollar so important in the global economy?

All central banks are born equal, but one is more equal than others


We focused heavily on the Fed here because pretty much all central banks have the same aims in the new post-GFC world and the Fed is the primary institution which market participants focus on.

At the end of the day, these are the institutions which primarily affect your wealth.

Not government.

Focus must shift to understanding what they do and how you are directly affected (or afflicted, which is the most common case).