Three Secrets Behind Central Bank Operations

In this article we will look at the world’s major central banks.

After reading this post, you will know the three secrets behind how every central bank functions.

This will help you to understand the causes behind long-term currency trends.

We will explore the following three secrets:

  1. The identity of the most influential central banks around the world
  2. How the structure of central banks helps decision-making
  3. The main tools used by central banks to impact the economy

Clearly identifying long-term currency trends will help to position yourself in the market and improve your trading results.

SECRET 1: The world’s most influential central banks

Every major country has a central bank. These global banks work with and against each other in order to achieve their goals.

The Federal Reserve

According to Investopedia, the Federal Reserve Bank in the US is the most influential central bank on the planet.

A 2018 study by Bloomberg also revealed that the Fed ranked number one for its economic forecasting accuracy.

One reason the Federal Reserve is so highly regarded is because its currency is the US Dollar. Remember, 90% of global currency transactions involve the US Dollar.

So when the Fed attempts to influence the value of its own currency, it also influences the valuations of almost every other currency.

This is why other central banks pay close attention to what the Federal Reserve does.

Traditionally, the three next most important central banks are the European Central Bank, the Bank of Japan and the Bank of England.

European Central Bank

The European Central Bank, or ECB as it’s more commonly known, was established in 1999. According to a 2016 HSBC study, over 30% of currency transactions involve the Euro.

The importance of the ECB is partly down to the fact that Europe is one of the world’s largest economies.

In 2017, the total GDP of the EU was 15 Trillion EUR, which represented over 22% of the global economy.

Bank Of Japan

The next bank that has major global influence is the Bank of Japan. The BOJ is responsible for printing new currency (JPY) for the Japanese economy.

A study of global FX volumes in 2016 shows that over 21% of currency transactions involve the Japanese Yen.

In fact, in between 2013 and 2016 Japan increased its overall FX trading volume from $374 Billion up to $399 Billion.

Bank Of England

The fourth most influential central bank is the Bank of England, or the BOE.

Despite the relatively small size of the UK, the British Pound is heavily involved in global FX transactions.

Its volume has grown consistently and in 2016 it hit $649 Billion with a 13% share in overall market trading volume.

Prior to the US Dollars rise, the British Pound was once the world’s main reserve currency.

According to Wikipedia, the British Pound represented 55% of global currency reserves in 1955 but by 2006 that percentage fell to just 2.5%.

Other Central Banks

Aside from these four major banks, there are a further four central banks that are widely regarded as the most influential.

These include the Swiss National Bank, the Bank of Canada, the Reserve Bank of Australia and the Reserve Bank of New Zealand.

Bloomberg cites the Bank of Canada as having the best track record when it comes to predicting inflation within its home economy.

In 2018, the eight banks listed above were responsible for much of the global economic activity and the monetary policy influencing it.

Interestingly, the oldest central bank in the world is none of these banks. It’s actually the Bank of Sweden.

It’s important to understand which central banks hold the biggest influence on the global currency markets.

Their related currencies often have more stable price movements and predictable long-term trends.

Trading stable currencies with predictable trends will generally improve your chances of generating a consistent profit.

SECRET 2: How Central Banks Make Decisions

The general structure of the major central banks is very similar. They consist of a group of people called a board. Boards are governed by a head person, called the governor.

The board will then regularly meet to discuss what the bank should do next with its monetary policy.

Following these discussions the board will vote on what to do next. The majority vote wins, before the board implement the winning motion.

Each bank has a different amount of members and different meeting schedules, but the general structure is the same.

The Reserve Bank of New Zealand is a curious exception to this rule. Rather than voting, they simply enact the wishes of their sole governor.

Who Owns Central Banks?

Generally speaking most central banks are independent of government and external influence.

There are some exceptions to this. For example, the US Federal Reserve is part owned by some commercial banks, although they receive no profits from their ownership.

Aside from this, there are only seven central banks around the world that are still privately owned in some capacity.

Each central bank has something called a mandate. This simply means a clear target or goal that the bank should be aiming for.

Most central banks have several targets – but the one that all banks share is the goal of keeping prices stable within their economy.

In other words, central banks prevent the costs of goods and services experiencing volatility.

The Federal Reserve – Guided By Law

Legislation dictates that the Federal Reserve follows the Federal Reserve Act. It must aim to achieve maximum employment, stable prices and moderate long-term interest rates

The Federal Open Market Committee (FOMC), which consists of 12 voting members, makes all monetary policy decisions for The Federal Reserve.

European Central Bank – Oversees 19 National Central Banks

The European Central Bank focuses on price stability – but it also has an interest in keeping the value of its currency low.

This is because Europe is dependent on selling its goods to foreign countries. A weak currency allows foreign buyers to afford the process of purchasing goods.

The European central bank consists of the 19 heads of the national central banks from each EU member country. There are also six members of the executive board.

Only 21 members get to vote during any given meeting. On a rotational basis, the central bank excludes four members from voting.

Bank Of Japan – 9 Voting Board Members

The Bank of Japan is one of two major central banks publicly listed on an exchange. This means that it is possible to buy shares in the bank.

Its board consists of nine voting members that are responsible for making decisions on monetary policy.

The Bank of Japan wants to keep its currency value low, as the Japanese economy is dependent on selling products to foreign buyers.

Bank Of England – 9 Voting Board Members

In the UK, the Bank of England holds almost 20% of the world’s gold in its secure underground vault.

Like the BOJ, it has nine voting members that decide monetary policy for the United Kingdom.

The board meet eight times each year and has a firm 2% target for the rate of inflation within the UK economy.

If inflation differs from the 2% target, the Bank of England’s governor writes a letter to the UK government explaining why.

Bank Of Canada – 13 Voting Board Members

The Bank of Canada consists of 14 members. Only 13 of these members have voting rights, including the governor.

Before the Bank of Canada’s inception in 1935, the Bank of Montreal was the country’s largest bank, acting as the government’s banker.

The BOC operates to keep prices stable – but it also has a target for inflation. Unlike the firm 2% target of the Bank of England, it aims to keep inflation within a band of 1-3%.

Swiss National Bank – 3 Voting Board Members

Located in the heart of Europe is the Swiss National Bank. Like the BOJ, it’s listed on a public exchange.

Because it is privately owned the bank has a council of 11 members. This council is responsible for the general business dealings of the bank.

The bank also has a governing board which is responsible for monetary policy in Switzerland.

This board consists of just three members and is one of the smallest voting boards in the world.

Reserve Bank Of Australia – 9 Voting Board Members

The final major bank is the Reserve Bank of Australia. The bank has a board of nine members that all have equal voting rights.

The members meet together eleven times each year, with nine meetings in Sydney and then two meetings in different Australian cities.

The RBA was one of the first central banks to act during a coordinated interest rate cut in 2008. The cut was in response to the worsening global financial crisis.

SECRET 3: Tools Used by Central Banks

Understanding the structure of central banks is only part of the equation.

To predict future currency trends, you need to also understand the tools that the banks use.

These tools are what directly impact the economy and success of each bank in relation to achieving their targets.

Central Bank Priorities

The number one priority for all central banks is to keep prices of goods and services within the economy stable.

Each bank has several tools at its disposal for making sure that prices are stable and that the economy is operating to its maximum potential.

In 2017 the Central Banking community named the Bank of England as the top performing central bank in terms of price stability.

The tools are virtually the same for all central banks around the world. Depending on economic circumstances, central banks use these tools at different times.

During the global financial crisis of 2008 central banks designed many new and innovative monetary policies to help them deal with those unique circumstances. Many of these tools are no longer in use.

In this article we will focus on only the major tools that are consistently used over time.

Interest Rates

The primary tool of every central bank is the adjustment of interest rates. When interest rates rise, the value of the currency rises and vice versa.

The interest rate is the amount that commercial banks must pay to borrow from the central bank.

If the rate is low, these savings often pass onto consumers in the economy.

If the rate is high, this means that consumers will also have to pay higher rates. This indirectly dictates the borrowing and saving rates throughout the economy.

Low interest rates encourage people to borrow and spend. This increases the amount of money circulating in the economy, which generates economic growth.

Economic growth allows more people to make more money, which increases the prosperity of a country.

High interest rates encourage people to save and invest. This decreases spending and helps to slow the rate of inflation.

Controlling price increases allows people of all income levels to participate in the economy and access the basic resources they need to live.

Interest rates dramatically impact people’s lives and the economy as a whole. That’s why they are the most important tool used by central banks.

In 2014, the Bank of England released a research paper to identify the impact of increasing interest rates.

The study revealed that increasing the interest rate by 1% would lower price increases by the same amount after three years.

Open Market Operations

Another common central bank tool is something called open market operations. There are two main ways that central banks carry out their open market operations.

The first is to buy or sell government bonds on the open market. The second is to allocate money to commercial banks for specific periods in exchange for collateral.

The general principle behind open market operations is for the central bank to influence the general money supply in the economy.

They can increase or decrease the supply of money by increasing or decreasing the supply of money to commercial banks.

When commercial banks have more cash available they will naturally seek to loan it out to their customers to generate more profits.

When there is less money, the banks will lend less capital and increase the cost of borrowing as a result.

The central banks are in the unique position of being able to create new money out of thin air, on demand. They can manipulate the money supply directly.

This ability gives them full control and influence over the whole banking system and the wider economy.

Commercial Banks

Central banks can also dictate the reserve requirements of all commercial banks operating within the country.

A reserve requirement is the amount of cash a commercial bank must have.

The figure changes as central banks try to influence the economy. For instance, the reserve requirement in the US is 10%.

If there is a reduction in the reserve requirement, then the commercial bank will start lending that money out for a profit instead of holding it.

This increases money supply and stimulates economic growth. If there is an increase in the reserve requirement, the opposite happens.

Of the eight most influential central banks in the world, only the Federal Reserve, ECB, BOJ and SNB require commercial banks to hold a reserve.

The BOE, BOC, RBNZ and RBA no longer have any kind of reserve requirements.

Controlling Money Supply

The tools that central banks use manipulate the amount of money flowing around the economy.

By controlling the money supply, they indirectly control personal and corporate behaviour, which in turn determines how stable prices remain.

Quantitative Easing

Perhaps the most powerful for achieving this control is quantitative easing. This tool became widely used in the aftermath of the 2008 financial crisis.

Quantitative easing intends to give the economy a stronger incentive to start spending and investing again.

The first bank to implement QE on a large scale in the modern era was the Bank of Japan back in 2001.

How QE Works

QE works through a series of steps:

One: The central bank begins buying existing assets, such as government or corporate bonds from private investors. This is all conducted electronically.

Two: The money is credited to the investor’s accounts in exchange for the assets.

Three: As the central bank continues buying on a large scale, the prices of those assets starts to rise. This makes the percentage return or yield fall.

Four: Investors now start buying other types of assets instead, to try and find a better return. These assets include things like stocks and shares and property. The reduced yields also lowers the cost of borrowing, which makes starting new businesses easier.

Five: Anyone that owns any kind of asset starts to see their wealth rise with the price of those assets. This gives people more confidence and makes them feel richer. This confidence encourages them to start spending more money, which in turn stimulates the economy.

The above steps lead to a new cycle of increased bank lending. This gives people and businesses more money to spend.

Extra spending inspires confidence, which encourages further spending, which helps to pull the country out of recession.

Over time, the economy then begins to operate near the central bank’s main targets. At this point, central banks can start using more conventional policies.

Helicopter Money

In 1969 the economist Milton Freidman proposed a more exciting version of quantitative easing called helicopter money.

Helicopter money would involve the central bank transferring money to people, rather than financial institutions and investors.

A 2014 study found that this type of operation would be far more effective at generating economic growth.

Many economists believe that this type of monetary policy is what central banks may start turning to over time.

The Art Of Communication

Despite these tools, central banks still rely on the art of communication to influence the markets and ensure price stability.

When a central bank clearly communicates its intentions the market can assess and react in the most appropriate manner.

Clear communication ensures that the market always has full confidence in a central bank.

This confidence breeds stability, as people understand that the bank is unlikely to surprise the market.

An Example Of Poor Communication

To illustrate how damaging poor communication can be, let’s look at the 2015 removal of the EUR/CHF currency floor by the SNB.

This episode wiped almost $100 billion off the Swiss stock market and caused the collapse of a $1 billion hedge fund.

This impact was primarily caused by the unexpected nature of the SNB’s announcement.

When they removed the 1.20 price floor, it came as a complete surprise to the market. They had earlier promised that the floor was to remain in place.

Because most central banks take care to communicate, the market takes their words seriously.

This means that if the bank wants to get the price of its currency down it only needs to threaten action.

These threats are usually enough for the market to start behaving as though the actions have actually been carried out.

A 2013 study of this type of communication from the RBA revealed that it can be very effective.

This is useful for central banks, because it allows them to enjoy the benefits of monetary policy without having to implement it.

This gives them greater scope to achieve the desired results within the economy and react to anything that requires action.

Summary of Central Bank Operations

In this article, we have looked at the most important central banks, their structure and the tools they use.

There are eight main central banks that influence the global economy. The most influential bank is the Federal Reserve in the US.

All central banks are structured in a similar way, with a voting board and head governor. The only exception is the Reserve Bank of New Zealand.

The main goal of all central banks is to maintain stable prices within the economy of their respective countries. Many banks also have a range of secondary objectives too.

Each bank has a variety of tools at their disposal, with interest rates and open market operations the most commonly used.

Central banks also strive to communicate clearly with the market at all times.

Understanding how central banks operate will help you to focus on the most stable currencies with the most predictable price movements.

Trading reliable currencies will improve your chances of making consistent profits over time.

If you have a topic that you’d like us to explain, then please type your suggestions in the comments section below.

Please also feel free to ask any further questions too. We read every comment and do our best to respond to your ideas.

Comments

comments

Facebook
Google+
Twitter
LinkedIn