Why are central banks so important to financial markets?

A central bank is often referred to as the “lender of last resort”. This means it is responsible for supplying funds to its nation’s economy when commercial banks are unable to meet a supply shortage. Basically, the central bank ensures the stability of the country’s banking system. In this article, we’ll explore the role of them and their importance to financial markets.

Main goal of central banks

The main goal of a central bank is to provide stability for their country’s currency by controlling inflation. Additionally, a central bank acts as the regulatory authority of a country’s monetary policy and is the exclusive provider and printer of the notes and coins in circulation.

Time has shown that a central bank operates most effectively when it is independent from government fiscal policy, avoiding influence from the political concerns of any regime and also be entirely free from any commercial interests.

How central banks influence financial markets

A central bank has two primary functions: macroeconomic when regulating inflation and price stability and microeconomic when functioning as a lender of last resort.

Macroeconomic role

Central banks play a crucial role in maintaining price stability and regulating inflation. They achieve this through monetary policy, which involves controlling the money supply. Performs open market transactions (OMO), injecting liquidity into the market or absorbing extra funds, which directly impacts inflation levels.

To increase the amount of money in circulation and lower borrowing costs, central banks can buy government bonds, bills, or other government-issued notes.

However, this buying can also lead to higher inflation. When the bank needs to absorb money to reduce inflation, it will sell government bonds on the open market, increasing interest rates and discouraging borrowing.

Open markets operations are the primary means by which a central bank controls inflation, money supply, and prices.

Microeconomic role

The role of central banks as lenders of last resort is to ensure stability in the financial system. A commercial bank offers funds to clients on a first-come, first-serve basis.

When commercial face liquidity shortages and cannot meet its customer demands, they can borrow funds from. This arrangement prevents favouritism towards any commercial bank. Many central banks enforce reserve requirements on commercial banks, based on a ratio of each commercial bank’s deposits.

For example, a central bank may require all commercial banks to keep a 1:10 reserve/deposit ratio. This policy of reserves functions as another way of controlling the money supply in the market. However, not all central banks, require commercial banks to deposit reserves.

The United Kingdom does not, while the United States traditionally did until recently dropping its reserve requirements to 0% during the 2020 COVID-19 pandemic.

The interest rate at which commercial banks and other can borrow short-term funds from the central bank is known as the discount rate.

To prevent excessive borrowing that disrupts monetary policy and the money supply, central banks set the discount rate strategically. If a commercial bank borrows too much, it increases the circulation of money in the system. The use of the discount rate can be restricted by making it unattractive when used repeatedly.

Importance of central banks

Central banks play a crucial role in global financial markets by regulating interest rates, which determine the cost of borrowing and lending money. They adjust rates to keep inflation within a predetermined range based on a country’s economic conditions.

Interest rate management is a powerful tool for central banks. Since interest rates impact borrowing and lending costs, they have a direct impact on economic activity.

For example, higher borrowing costs mean people with existing debt have less disposable income. They may delay economic activities like buying a home until interest rates decrease. With fewer people spending money, it leads to lower demand for goods and services, slowing inflation.

On the other hand, when interest rates are low, borrowing is cheaper. Increased spending boosts demand for goods and services, and this results in prices rising.

All central banks ensure the stability of the financial system and control the money supply. The United States Federal Reserve (the Fed), also aim to achieve additional economic goals such as achieving full employment.

Central banks and volatility

Central banks can significantly influence market volatility. Investors closely monitor decisions, and the statements of key monetary policy makers. Sudden market movements in financial markets often result directly from these statements, as they shape investor expectations.

The Swiss Flash Crash

One of the most well-known market events in recent years was driven by a central bank decision. On January 15, 2015, the Swiss National Bank (SNB) shocked the markets with an announcement that shook up the foreign exchange market.

The SNB had been intervening in the market to keep the value of the euro above 1.20 Swiss francs. They did this by setting a floor on the euro-Swiss franc exchange rate (EUR/CHF) at 1.20. However, in January 2015, the SNB surprised markets by removing this floor. This caused the euro’s value against the Swiss franc to fall dramatically from 1.20 to 0.80 almost instantly.

This event, known as the Swiss Flash Crash, led to significant losses for those holding long positions in the EUR/CHF exchange. This unexpected decision by the SNB caused many long positions to close simultaneously, rapidly decreasing their value. Few people benefited from this market movement as downside positions were nearly non-existent due to the SNB’s previous position to maintain the exchange rate above 1.20.

Marios Draghi’s ‘whatever it takes’ speech

The European Central Bank (ECB) is another example of how central banks can move markets. On 25 July 2012, as the European single currency was facing a severe credibility crisis, ECB President Mario Draghi made a public speech in London.

His speech, which would be remembered for his promise to do ‘whatever it takes’, helped restore confidence in the eurozone and generated a strong movement in bond markets.

This time, it wasn’t a formal decision by the central bank’s governing council that moved the market, but the words of its president in a public statement.

History of central banks

The establishment of central banks goes back to the 17th century. The Bank of Sweden (Sveriges Riksbank), founded in 1668, is one of the central banks whose origins can be traced back to this period.

Many central banks began as private companies before transitioning to public institutions, gaining prominence over time.

The US Federal Reserve (Fed) was established in 1913 in response to a series of financial crises that gripped the country around the turn of the century.

In Europe, the European Central Bank (ECB) was founded with the aim of creating a unified economic region with a single currency. While the Eurozone states retain their national central banks, their functions have been reduced through integration into the ECB.

Major central banks

Federal Reserve (Fed)

As the central bank of the United States, the Fed oversees the world’s largest economy and closely monitors the dollar; the currency with the biggest impact on all global trade transactions. The Federal Open Market Committee (FOMC), its governing body, meets eight times a year. The press conference held by its chairman after each meeting usually triggers market volatility. Investors and traders closely watch the markets when these announcements are expected.

The European Central Bank (ECB)

The ECB holds substantial market influence due to the dominance of the euro as a reference currency. The ECB’s Governing Council, comprised of the central bankers from all eurozone member countries, meets every six weeks to set and announce the ECB’s monetary policy.

The Bank of Japan (BoJ)

Ranked among the top three major central banks, the Monetary Policy Board meets monthly. It is known globally for its ultra-expansive policies, which inject a lot of money into the economy, both directly and indirectly.

Bank of England (BoE)

This body ensures the efficiency of the financial system across the United Kingdom. Similar to the Fed’s FOMC, the BoE’s Monetary Policy Committee (MPC) meets eight times a year.

People’s Bank of China (PBoC)

While this entity does not meet regularly, and China’s economy is closely regulated by the government, the PBoC’s interest rate decisions are becoming an important appointment on the investor’s agenda as the yuan becomes more globally relevant

Responding to central bank announcements

Keeping a close watch on interest rate announcements is critical for active participants in the economy, especially for traders and investors who need to react quickly to market movements.

They often have the most impact on currency and bond markets, often triggering ripple effects across stocks and commodities.

You must stay well-informed, prioritise risk management, be ready to react swiftly and capitalise on all market fluctuations. Remember that initial market reactions may reverse once the situation is stable, presenting new opportunities following the original market shift.

Disclaimer:
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.