The central bank has privileged control over the money and credit generation and distribution for a nation or group of countries. The Central Bank is usually responsible for formulating monetary policy and regulating Member States' economies in modern economies.
Inherently, central banks are non-market institutions or even anti-concurring ones. Although many central banks are nationalized, many are not government agencies and are therefore often considered politically independent. Although central banks do not legally belong to the government, their privileges are set up and protected by law.
A central bank — which distinguishes it from other banks — is critically responsible for its legal monopoly, which gives it the privilege to issue bills and cash. Only private commercial banks can issue claim liabilities, including checking deposits.
The duties of central banks and the rationale behind their existence are usually covered by three areas, although they are very diverse, depending on the country. The first is to dominate and control the supply of national monetary resources by central banks.
Central banks usually raise interest rates to reduce growth and avoid inflation; reduce them to encourage growth, industry, and consumer expenditure. They manage monetary policy to guide the country's economy and achieve economic objectives, for example, full employment.
Secondly, member banks' regulation involves capital requirements, lending rates (which dictate how much and how much cash banks can lend to customers), and deposit guarantees, among other instruments. The latest regulations include The banks and their governments also provide loans and services and manage foreign exchange reserves.
Lastly, a central bank also provides emergency lenders, sometimes even for the government, to distressed commercial and other institutions. For example, the central bank offers a politically lucrative alternative to effective taxation by purchasing government debt obligations when a government needs to raise revenue.
In addition to the above measures, central banks have other measures available. For instance, in the United States, the central bank is the Fed. By changing reserve requirements, the Federal Reserve Board, the Fed's ruling body, may influence the national money supply. When minimum requirements fall, banks can borrow more money, and the economy's money supply increases. In contrast, the increase in reserve demands reduces the supply of money.
If the Fed decreases the discount rate on the short-term loans paid by banks, liquidity increases. Lower rates increase the supply of money, thereby boosting economic activity. But falling interest rates can stimulate inflation, so the Fed needs to be vigilant.
And, to change federal funds, the Fed can operate openly on the market. The Fed purchases government securities from securities dealers to provide cash and thereby increases the supply of money. The Fed sells securities to transfer the funds to and from its bags.
Concern about deflation has increased in the last quarter of a century following major financial crises. Japan offered the sobering example. In 1989-1990, the Nikkei index lost one-third of Nike's value within the year after it's stock and real estate bubbles erupted, and deflation shrank. One of the fastest-growing Japanese economy in the world slowed dramatically between the 1960s and the 1980s. The 1990s were called the Lost Decade of Japan. In 2013, Japan's nominal GDP in the mid-1990s was still approximately 6% below its level.
The 2008-2009 Great Recession sparked fears of a similar lengthy deflation in and around the United States due to the catastrophic collapse of asset prices. Several major banks and financial institutions in the United States and Europe, exemplified by Lehman Brothers' collapse in September 2008, were also throwing the global financial system into turmoil.
As a result, two fundamental types of monetary policy unconventional tools were used as the Federal Open Market Committee or FOMC, the monetary policy body by the Federal Reserve:
(1) Forward policy direction
(2) Major asset acquisitions
First, the federal target rate was mainly cut to nil and kept there at least by mid-2013. However, it is the other tool, quantitative easing, which hogged the headlines and is synonymous with the Fed's policy on easy money. QE mainly involves creating new money and its use to buy securities from the national banks so that liquidity is pumped into the economy, and long-term interest rates are reduced. It permitted the Fed to purchase risky assets, including mortgage-backed securities and other NGO debt.
This has spread to other economic interest rates, and the widespread interest rate decreases, stimulating the demand for consumer and corporate loans. Because of the funds they received from the central bank in exchange for the securities they hold, banks can meet this higher demand for loans.
In January 2015, by committing to buy at least €1.1 billion in bonds at a monthly rate between €60 billion and September 2016, the European Central Bank (ECB) embarked on its version of QE. After the unprecedented move to reduce the rate of benchmark loans below 0% by late 2014, the ECB launched its QE program after 6 years upon the Reserve showing support to Europe's fragile restoration and prevent deflation.
The ECB was the first major central bank to push its benchmark interest rates under the zero limit, many central banks in Europe, including those of Sweden, Denmark, and Switzerland.
Central banks' actions seem to win the fight to deflation, but it is too soon to tell if they have won the war. In the meantime, concerted efforts to combat global deflation have had a strange impact:
QE might lead to a hidden monetary war: QE programs resulted in significant currencies sinking against U.S. dollars across the board. Since almost all options for stimulating growth have been exhausted in many countries, depreciation may be the only remaining tool for boosting economic growth, leading to a covert currency war.
Bond yields from Europe have turned negative. More than a quarter of an estimated 1.5 trillion dollars of debt issued by European governments now negatively returns. This may be due to the ECB's bond purchase program, but it could signal a sharp future slowdown.
Central bank balances blow up: the Federal Reserve, the Bank of Japan's and the ECB's large-scale asset purchases boost their balance sheets to record levels. Shrinking the balance sheets of these central banks can have negative consequences.
Oct 08, 2020