Roy Davidson, 10 July 2019

In this article we explain the role of central banks, how the main functions of central banks have evolved over time, and why investors pay such close attention to their actions.

What are central banks?

Central banks are in charge of a country’s money supply and act as the banker to the banks. They are also the lender of last resort, meaning they will, at all times, lend to commercial banks to ensure their solvency.

Central banks are responsible for setting and implementing a country’s monetary policy. The most common way monetary policy is conducted is by setting the rate at which the central bank will lend to banks. In New Zealand and Australia this is termed the Official Cash Rate. Changes in the Official Cash Rate impact all interest rates (for example, mortgage rates) which can boost or constrain economic activity.

In addition, central banks may purchase financial assets to influence interest rates (sometimes called open market operations or quantitative easing), or set limits on commercial bank lending activity (also known as macro-prudential measures).

Notable central banks include the Reserve Bank of New Zealand, the Reserve Bank of Australia, the Federal Reserve in the US, the European Central Bank, and the Bank of England.

What do central banks do?

Early central banks were essentially used by political leaders to fund their spending, in exchange for a monopoly over the issuance of bank notes. In fact, one of the first central banks, the Bank of England (established in 1694) was established for the express purpose of funding William III’s Nine Years’ War with France.

Over time, and in the wake of several episodes of painfully high inflation, central banks’ independence came to be seen as paramount in order to ensure the appropriate implementation of monetary policy. Politicians venture into dangerous territory when they attempt to influence central bank actions. Nonetheless, the Government maintains overall responsibility for economic policy, often setting the monetary policy goals and delegating implementation to the central bank.

The Reserve Bank of New Zealand’s independence was cemented in 1989, and its goals are set out in the Policy Target Agreement it maintains with the Government. This agreement is periodically reviewed.

While the role of central banks has varied over the years, by and large the main goals of central banks in developed markets today are to keep inflation in check and ensure financial stability. The Reserve Bank of New Zealand, for example, has a mandate to keep inflation between 1-3% over the medium term, with 2% the target. Recently, this has been extended to explicitly require the Reserve Bank of New Zealand to contribute to maintaining ‘maximum sustainable employment.’

The Reserve Bank of New Zealand was a pioneer of inflation targeting, and has more recently been a pioneer of macro-prudential measures. These have involved placing limits on commercial bank lending activity (for example, the share of new lending that can be made to investors or borrowers with smaller deposits) in an attempt to take the heat out of the housing market.

Why is there so much focus on the actions of central banks?

As central banks are responsible for a country’s monetary policy, those working in financial markets spend a good chunk of time trying to predict what central banks might do next. While monetary policy actions may slip under most people’s radar, being less visible than government spending decisions (known as fiscal policy), it is very important when assessing the outlook for economic growth and markets.

Generally speaking, lower interest rates are positive for economic growth. They enable businesses to more readily borrow money and spur economic activity, and also boost consumer spending. Lower interest rates are, however, disadvantageous to savers who now receive lower interest returns on their savings. Prolonged periods of low interest rates can also create distortions in the economy, causing problems down the track when interest rates rise again.

With interest rates having been so low across the globe since the Global Financial Crisis, much attention is placed on whether central banks will be able to ‘tighten’ monetary policy (i.e. lift interest rates). This is particularly true of arguably the world’s most important central bank, the US Federal Reserve, which has recently halted its tightening plans following a period of economic weakness.