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What is a central bank?

A central bank is a public institution responsible for implementing monetary policy, managing a country’s currency or a group of countries, and controlling the money supply.

The purpose of central banks

The typical focus of central banks is generally three-fold:

Firstly, to ensure stable inflation around a target level. This tends to be 2% in the major nations, although for emerging markets this is typically higher.
Secondly, to promote employment in the country.
Lastly (a mandate of higher importance for developing countries) to ensure currency stability.
How do central banks set monetary policy

The main tool at the disposal of central banks is setting the level of interest rates. Central banks are effectively banks for commercial banks. So when central banks raise their base rate, this is not directly passed onto consumers, but it raises the interest rate available to commercial banks that hold money at the central bank. This is then indirectly passed onto consumers by those commercial banks, thus spreading the changes in central bank rates through the economy.

Why do central banks change interest rates?

Central banks will either raise or cut interest rates to achieve the mandates mentioned above, chief among which is ensuring price stability. Central banks view low and stable inflation as highly desirable, as this allows individuals and households to plan both their future savings and consumption, breeding confidence and supporting economic expansion.

How can a central bank combat high inflation?

During periods of high inflation, and strong growth, central banks will raise interest rates, typically in 25bp increments. How do higher rates impact economies? For starters, higher borrowing costs, particularly higher mortgage rates, lead to lower disposable incomes for households and, therefore, lower spending. Higher interest rates discourage household borrowing, encouraging individuals to save and spend less. For businesses, the increase in borrowing and investment costs further dampens economic activity, typically leading to fewer jobs and higher unemployment, which weighs on consumer spending activity, lowers growth and reduces inflation.

What happens when interest rates reach zero?

This is a relatively new phenomenon that first arose following the global financial crisis in 2008-09 when central banks introduced what is known as quantitative easing. This is a process whereby central banks purchase government securities, typically bonds, raising the prices of those bonds and thus lowering their interest rates.

Quantitative tightening is precisely the opposite, whereby these central banks are now lowering their holdings of government bonds in a process called balance sheet normalisation.

How do central bank rates impact currencies?

The rule of thumb is that an increase in central bank rates, known as policy tightening, is seen as bullish and should lead to an appreciation in the domestic currency. On the other hand, central bank rate cuts, known as policy loosening, are seen as bearish and should lead to a depreciation in the domestic currency.

In reality, it’s more complicated, as markets are not just interested in the change in rates itself, but also expectations for future interest rates and the change in interest rate differentials for a particular currency pair.

If, for argument’s sake, the Bank of England is expected to raise interest rates in a month, then the market will position itself for such an eventuality by pricing this into the value of sterling. In other words, the pound will strengthen in anticipation of this rate hike and weaken in anticipation of a rate cut.

For the GBP/USD pair, investors will also consider what the Federal Reserve, the central bank in the US, is doing with its monetary policy. If the Fed also raises rates, and at a faster pace than the BoE, it would be seen as bearish for the pound against the dollar.

During central bank meetings, which among the majors, typically occur every month or six weeks, markets also pay close attention to the bank’s communications, or forward guidance, on future policy moves. When we refer to a ‘hawkish’ set of communications, it indicates one’s preference towards higher rates, whereas dovish refers to the preference for lower rates.

The importance of central bank foreign exchange reserves

Aside from merely setting interest rates, central banks have several other tools at their disposal to meet their mandates. In some cases, most predominantly among emerging markets, these central banks will occasionally intervene in the currency market to influence the value of their currency’s exchange rate.

Every central bank holds what are known as foreign exchange reserves. These reserves, which typically consist primarily, but not entirely, of the US dollar, are purchased or sold by central banks to manipulate demand for the domestic currency.

Measures taken by the central bank during currency depreciation

Depreciation in a currency’s value tends to push up domestic prices, so during periods of excessive currency weakness, a central bank may intervene by selling its foreign exchange reserves, and buying the domestic currency, therefore propping it up.

Measures taken by central bank during currency appreciation

Too strong of a currency is also undesirable, as this can harm a country’s export competitiveness. In this instance, a central bank may purchase additional FX reserves, therefore selling its domestic currency holdings, leading to a depreciation in the exchange rate.

What is currency pegging?

In extreme cases, currencies are pegged to the value of another, usually the dollar or the euro. When this is the case, these central banks need to accumulate a sufficient amount of FX reserves, in relation to the value of the imports to deter a speculative attack on the currency. These central banks are also forced to follow the same monetary policy as the currency they are pegged to. For instance, when the Federal Reserve hikes interest rates by 25bps, the central bank in the UAE, which pegs its currency to the dollar, will have to follow suit with a 25bp rate increase on its own.

Conclusion

Central banks are the most influential financial institutions, as they hold power to drive money creation, money supply and even currency value to a large extent. It is prudent for businesses, no matter small, medium or large, to keep up to date with the central bank’s measures and their impact on interest rates, currency value and many more. The currency fluctuations due to central bank policy or other global factors can negatively influence your profit margins if left untouched.

Ebury offers a comprehensive and bespoke hedging solution to help you protect your business from currency movements. Our team of FX experts will understand your industry, business needs, risk tolerance, budget and goals to design a solution that best fits your business.

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