A central bank is a financial institution that manages the monetary policy and currency supply of a country or group of countries. It is typically responsible for maintaining stability in the financial system. This includes the stability of prices and promoting economic growth. Although some are nationalised, a central bank usually operates independently of a country’s government but is intrinsically non-market-based. It is also not competitive. The central bank’s primary focus is to make decisions that are in the economy’s best interest.
Central banks and forex
Central banks play a significant role in the foreign exchange market. This is due to their ability to influence the supply and demand of a currency, and therefore its exchange rate.
Central banks typically use monetary policy tools like setting interest rates and adjusting money supply to influence the exchange rate of their currency. How?
- Money supply: An increase in money supply can lead to a rise in inflation and a depreciation of the currency. Alternatively, a decrease in the money supply can lead to a decrease in inflation and an appreciation of the currency. Both scenarios may impact exchange rates, either negatively or positively.
- Interest rates: Central banks can adjust their interest rates to make their currency more (or less) attractive to foreign investors. A higher interest rate typically makes a currency more appealing to investors as it provides a higher return on investment. This in turn can lead to an increase in demand for the currency and an appreciation of its exchange rate.
Core functions of central banks
Central banks undertake several vital activities to maintain the financial and economic stability of countries like:
- Enacts monetary policy: The central bank regulates the amount of money in circulation, easing or tightening supply and availability of credit as required. It does this to control inflation and to keep a country’s economy stable.
- Regulate interest rates: Central banks may raise or lower interest rates to slow down, spur growth, and manage inflation.
- Oversees the banking industry: The central bank sets the requirements for banks and other financial institutions. This includes cash requirements, capital requirements and deposit guarantees. The objective is to ensure the banking system in its entirety operates in a way that ensures financial stability.
- Loans and services: The central bank may provide loans and services to a country’s banks and government.
- Emergency lender: The central bank may act as a lender of last resort, providing loans to distressed financial institutions and sometimes governments. This occurs primarily in times of crisis and is aimed at preventing a collapse of the financial system.
Some of the world’s most prominent central banks
Central banks across the globe seek to ensure the reliability and stability of a nation’s financial systems. These are some of the most notable central banks worldwide:
1. Federal Reserve
The Federal Reserve System (the Fed) is the central bank of the United States. Created in December 1913, it is today one of the most powerful central banks worldwide. The US Federal Reserve has several essential functions. It is responsible for promoting monetary policy, regulating the banking system, and maintaining stability in the financial system. It also oversees consumer protection and seeks to ensure the safety of payment and settlement systems. The Fed is controlled by Congress.
How is the Fed structured?
The Fed is comprised of three distinct groups. The first is a board consisting of 7 governors or board members nominated by the U.S. President and confirmed by the U.S. Senate. While acting independently of the U.S. government, the board is required to report to Congress. Their role is to maintain the objectives of the Fed.
The second group is the Federal Reserve Banks which are 12 regional banks that manage different regions of the United States. The Fed’s board is responsible for its supervision. These banks are found in New York, Boston, Cleveland, Atlanta, Philadelphia, Richmond, Chicago, Minneapolis, Kansas City, St. Louis, San Francisco, and Dallas.
The 3rd group is the FOMC (The Federal Open Market Committee). The FOMC is comprised of the Fed’s board members plus the 12 presidents of the reserve banks. The Head of the Federal Reserve Board acts as the FOMC chair. The FOMC meets eight times a year, during which time it assesses economic conditions, the stability of the financial system, and monetary policy.
2. The European Central Bank (ECB)
Formed in 1999, the ECB is governed by a council of 6 members of its executive board, together with the governors of all national central banks from 19 eurozone countries. The council manages amendments to monetary policy. The ECB’s primary goal is to ensure price stability and sustainable growth. It monitors the annual growth of consumer prices (to keep below 2%) and monitors the strength of its currency to reduce risk in its export market.
3. The Bank of England (BoE)
Established in 1694, the Bank of England is the central bank of the United Kingdom headquartered in London. It is thought to be one of the oldest banks on the globe. It is also renowned for the role it has played in establishing modern monetary practices. The BoE focuses on the soundness of its monetary and financial systems by closely monitoring inflation. It also ensures the security of its currency.
4. The Swiss National Bank (SNB)
The goal of this independent bank is to maintain price stability and oversee the country’s economic conditions. The bank operates from Berne and Zurich. Due to Switzerland’s dependence on exports, the SNB monitors the strength of its currency closely, acting conservatively with rate increases.
5. Bank of Japan (BOJ)
The Bank of Japan plays an important role in the country’s economy, particularly in terms of money supply and inflation. Headquartered in Tokyo, Japan’s central bank is responsible for issuing and managing currency and treasury securities. Like other central banks, it conducts economic research and analysis.
Several other influential central banks exist such as the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, etc. Each of these central banks plays an integral role in the stability of their country’s economic and financial systems.
While the specific functions or structure of each central bank may vary, the want for economic stability and currency control remains standard worldwide. Central banks play crucial roles in maintaining this stability to achieve healthy economic growth and to ensure prices remain stable. They do this using a variety of different monetary policy tools to ensure objectives are as far as possible achieved.
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked, in this communication.