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What will central banks do if economies rise or decline?

February 4th, 2021 -

About 7 Mins
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Are monetary policies going to be accommodative or will central banks have to act quickly?

Central banks across the globe have had to act fast in light of the pandemic to stabilise local economies and enable liquidity and lending through banks. Many have had experience with dealing with serious instability caused by the global financial crisis in 2007-2008 (GFC). Despite being very different in many respects to the current pandemic, past responses of central banks have given the market fairly recent data and insight in how central banks could or shouldn’t respond when faced with such a significant crisis.

So, how do central banks respond and how does what they do impact on local and global economies? And how quickly do their measures make an impact?

What mandates do central banks have?

If you’re familiar with the main roles and mandates of central banks you may want to skip over this section, but for many it’s good to understand how central banks are set up and what their main objectives are.

In many cases central banks are separate independent institutions run by a board of directors, committee (or similar) that are not directly influenced by political parties but have a longterm mandate by their local parliament or congress for a specific inflation rate (often around 2%), or to maintain price stability. 

Not all central banks have the same mandate from their local governments. The Federal Reserve (the central bank of the United States) has a clear mandate from Congress: “to promote maximum employment, stable prices, and moderate long-term interest rates.”

Other central banks, such as the European Central Bank (ECB) have the mandate of price stability and sustainable growth.

Inflation targeting is often the leading framework for monetary policies deployed by Central Banks such as Canada, the UK, New Zealand and elsewhere

A few countries still deploy fixed exchange rate mandates where local currencies are fixed or ‘pegged’ to one specific currency (e.g. the dollar), a basket of currencies or another asset such as gold, but many low income countries are trying to transition to an inflation target mandate which allows for greater influence on the economy through changing interest rates.

Monetary and fiscal policy

It’s important to understand that central banks are responsible for monetary policy and not fiscal policy. Fiscal policy is what governments do in order to boost local economies. This could be in the form of tax cuts, government grants or similar.

Monetary policy in countries with inflation targeting usually focuses on the adjustment of interest rates by the central bank to encourage (or discourage) lending between banks, and from banks to businesses and consumers.

However, both monetary and fiscal policy often have a significant impact on local economies and exchange rates and both can work in tandem. Countries such as the UK for example have attempted to work more closely together through the crisis to ensure fiscal and monetary policy are working more effectively.

Quantitative easing and other levers central banks deploy in a crisis

In a crisis such as the pandemic we’ve been experiencing globally, the Federal Reserve cut interest rates as much as possible to enable cheaper lending and liquidity for businesses. A central bank’s main mandate is often price stability and this is what they tend to focus on in the first instance. Another thing they can do and some, such as the ECB, have done recently is to ease off insurance or asset requirements for banks to make it easier for banks to operate and lend.

In addition to this central banks tend to have responsibility for a large balance sheet of assets and can print money (however this is not a tactic deployed often, due to historically well documented hyperinflation disasters).

One way central banks can finance government spending or provide local banks with more finance is by increasing their balance sheet, i.e. purchasing large amounts of government bonds or other assets which they may have refrained from acquiring in the past (such as corporate bonds). This injects ‘digital money’ into the economy and helps to further lower interest rates.

This approach is often referred to as quantitative easing and it’s an approach the Federal Reserve and the Bank of England have taken during the last financial crisis and more recently during the pandemic. The Federal Reserve’s balance sheet is published every Thursday and it makes for very interesting reading.     

How quickly do central banks act?

Most central banks meet at regular intervals throughout the year to announce whether they cut, increase or lower interest rate and markets respond quickly to those important announcements.

However, in contrast to interest rate adjustments that come into effect immediately, some policies or actions take longer to show their impact.

The increased balance sheet of the Federal Reserve due to the GFC took many years to lower again, and it has almost doubled again in size since the pandemic began. Selling off these assets will most likely be a controlled process that will take years.

The ECB has been open and transparent with its recent measures and publicly available interviews with ECB economists suggest that the ECB sees the need to provide pandemic related stabilising support until 2022/2023, suggesting that many of their current measures could be in place longer term. 

Suffice to say, that the road to recovery from the drastic measures taken to date will take quite some time to undo. We can also expect further interest rate cuts and quantitative easing this year by different central banks as some economies are likely to hit double recessions in the coming months.

Unlike the few places that managed to contain the virus early on it looks like it could take some time before economies show significant signs of recovery and central banks change tact.

This content is provided for general information purposes only and is not to be taken as investment advice nor as a recommendation for any security, investment strategy or investment account.

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