Monetary policy occupies a central place in fundamental analysis. It is conducted by central banks and influences the economy through changes in the money supply and lending conditions.

This powerful institution is headed by a governor. The administrative format and powers within different central banks vary. In the most general sense, the purpose of monetary policy is to support the economy through the different stages of the economic cycle.

Traditionally, the objectives are oriented towards achieving price stability and optimal employment levels.

“The Federal Open Market Committee sets U.S. monetary policy in accordance with its mandate from Congress: to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy.” – Federal Reserve.

“The primary objective of the European System of Central Banks […] shall be to maintain price stability.” – European Central Bank

The relevant governing bodies shall take their decisions at periodic meetings. Communicating this information often leads to high volatility (sharp market movements) in financial markets, especially when the new information is unexpected by the audience. Through their policies, central banks have an impact on virtually all economic entities – starting with the banking sector directly linked to them and reaching the end users of financial products such as businesses and households.

The focus of the fundamental analysis is mostly on the central banks representing the major currencies – the US Federal Reserve (USD), the European Central Bank (EUR), the Bank of Japan (JPY), the Australian (AUD), New Zealand (NZD), Canadian (CAD), British (GBP) and Swiss (CHF) central banks.

The US Federal Reserve, also known as the Fed, undoubtedly has the greatest influence over global financial processes. The importance of this institution may become clear to us by taking a quick look at the US dollar – the world’s main reserve currency and a key one for trade in commodities.

In the lines that follow, we will be talking primarily about the Fed, but similar policies are pursued by other central banks of developed economies.

Open Market Operations

The Fed is engaged in day-to-day operations of buying and selling government and agency securities in the open market. This is one of the oldest and most traditional mechanisms for controlling the amount of money in circulation, through which the target federal funds rate is achieved.

The FOMC (Federal Open Market Committee) sets the targets, and the Federal Reserve Bank of New York transacts with primary dealers to implement them. When the Fed wants to inject liquidity into the system, it buys government debt. This increases the reserves in the banking system. Banks, in turn, prefer to lend at lower interest rates rather than maintain excess reserves.

If the Fed wants to limit the money supply, it can start a series of sales of government bonds in the open market. Reserves in the banking system will decrease, which will lead to a rise in interest rates.

The Central Bank’s Policy Rate:

The structural determinant of monetary policy is the official interest rate. By raising the policy rate, the central bank seeks to cool the economy by restricting the money supply and making lending more expensive.

We remember the opposite case from the Global Financial Crisis of 2007 and the Covid-19 crisis of 2020. Back then, central banks lowered interest rates dramatically in an effort to increase the money supply in circulation and facilitate access to loan products. Some central banks around the world reached negative interest rates – a precedent in history.

The central bank is the lender of last resort. It sets the interest rates at which commercial banks can borrow from it. At the Fed, this interest rate is called the discount rate.

When the discount rate changes, commercial banks in turn adjust the rates on their credit products. They are obliged to go along with the central bank’s wishes, since they would not risk borrowing from it on terms less favorable than those granted to their own customers.

But why would they need to borrow from the central bank?

The Fed could undertake a series of open market operations to reduce the money supply. A liquidity shortage would force the banking sector to launch a series of repo transactions (short-term borrowing from the central bank backed by bonds). These transactions usually last from one day to two weeks.

The effective interest rate at which the repos will be concluded will be the discount rate already set by the Fed (for the ECB this rate is called the main refinancing rate).

In the United States, the federal funds rate – the overnight rate on the federal interbank market – is of greater interest to investors. The FOMC sets a target range for this rate (e.g., 1.25%-1.5%). The mechanism by which it is able to enforce effective lending at the rates it sets is related to reserve requirements held at the central bank by certain financial institutions (depository institutions such as banks, savings institutions, credit unions, and U.S. branches of foreign banks) and selected other institutions (the Federal Home Loan Banks and other government-sponsored enterprises).

If at the end of the day any of these institutions has excess reserves, it will try to make an overnight loan for the excess to another bank that is experiencing a reserve shortage. The transaction would occur at interest rates close to the target federal funds rate.

If the Fed aims to lower the fed funds rate, it will start bond buying operations from the open market. The inflow of cash into the banking system will lead to excess reserves. Banks will lower the overnight interest rate to dispose of the excess.

If the goal is a rise in the federal funds rate, the Fed will start selling government securities, sucking liquidity out of the banking system. Reserves will decline and the overnight interest rate will rise.

The Fed’s monetary policy is set by the FOMC (Federal Open Market Committee) during its eight annual meetings. When the situation is extreme (such as the Covid-19 pandemic), emergency meetings can be called.

The European Central Bank (ECB) applies similar mechanisms to euro area banks (countries that have adopted the euro). It sets three types of interest rates:

  • MRO (main refinancing operations) – at these rates, commercial banks can obtain a one-week loan from the ECB.
  • Rate of marginal lending facility – the interest rate for an overnight loan from the ECB. It is higher than the MRO.
  • Rate of the deposit facility – the overnight rate at which banks can deposit reserves with the central bank.

In an effort to stimulate lending in the euro area, the ECB lowered the interest rate of the deposit facility to -0.5% in 2019. In doing so, it induced banks to provide cheaper loans, with the alternative of paying to keep their funds parked at the ECB.

Euro-zone banks lend short-term euro loans to each other (from a week to a year) at rates called Euribor (Euro Interbank Offer Rate). These are essentially repo operations between individual European banks. These rates are used as a benchmark when setting interest rates for other loan products. For example, a mortgage loan from a bank in the euro area may be granted at Euribor +3%.

Libor (London Interbank Offer Rate) is used as a benchmark in the international interbank market. At these rates, major global banks lend short-term loans to each other (*Libor is in the process of being replaced by other alternative indices as SOFR – Secured Overnight Financing Rate (SOFR).

 

Let’s look at the following hypothetical example to illustrate the reasons for the Fed’s monetary decisions and their consequences:

The U.S. economy has been on an upward trend in recent years. GDP, as well as inflation, has been growing at a high rate. Businesses are making big profits. The production facilities are operating at full capacity. Unemployment is extremely low and wages are soaring.

Under these conditions, the central bank’s concerns will be related to the risk of overheating of the economy. If inflation gets out of control, the damage could be significant.

To cool the intentions of businesses and individual consumers, the Fed will increase federal funds rates. To that end, it will restrict the money supply through open market operations. Reserves in the banking system will decline and the overnight interest rate will begin to rise until it reaches the central bank’s target levels.

As a result, commercial banks will offer more expensive credit to their customers. Many companies and households may find it more tempting to deposit than to take out investment loans. As a final result, the economy will slow down and the rate of inflation will fall. Unfortunately, that cycle usually ends with a recession.

In the opposite scenario, in which the economy slows down and inflation is below the central bank’s target, a stimulative interest rate policy would be pursued. The Fed would transact in the open market to increase the money supply. Commercial banks will offer more attractive loans in order not to accumulate excess reserves. End users will find it easier to finance their ideas.

By targeting the federal funds rate, the central bank controls the amount of money in circulation.

When the economy overheats – the money supply is restricted. When the economy slows down – the money supply increases.

Reserve Requirements

Banks are required to maintain regulatory reserves. When an administrative decision is taken to increase reserve requirements, the funds available for lending in the banking system decrease. When reserve requirements are reduced, more liquid funds remain available in banks.

The Fed pays interest on bank reserves parked with it. This is a kind of compensation for banks that keep their resources locked up. The Fed also pays interest on parked excess reserves – funds in excess of regulatory requirements. Changing these interest rates is an additional tool for conducting monetary policies.

As mentioned, the ECB imposed negative interest rates on reserves in 2019 in an apparent effort to discourage banks from maintaining excess reserves.

During the last two crises – the global financial crisis of 2007 and the COVID-19 crisis of 2020, central banks around the world have enriched their methods and tools.

In addition to the three traditional monetary policy tools described above (open market operations, policy rate and reserves), the Fed has added two new ones – quantitative stimulus and forward guidance.

Large Scale Asset Purchases   

The asset purchase program has become a key tool for central banks to address the Global Financial Crisis and its economic fallout.

This monetary policy tool is most effectively applied when the official interest rate has reached levels around zero and the effects of lowering it further are limited.

The most commonly purchased assets are government securities and mortgage-backed securities. The aim is to inject fresh funds into the banking system which it can transfer to the real economy.

Asset purchase programs during the Global Financial Crisis have varied across central banks but are generally referred to as quantitative easing. For example, the Fed aggressively targeted mortgage-backed securities (MBS), which were largely at the heart of the global financial crisis.

The Global Financial Crisis – recap!

We recall that the beginning of the crisis was triggered by the bursting of the mortgage bubble. After a period of high supply, steadily rising prices and lower criteria for granting housing loans, the sector overheated. When the economy slowed down and prices started to fall, the whole system collapsed in an avalanche.

A number of consumers were unable to pay their mortgages or found it better not to. These properties were returned to the banks, and they had to sell them in a steadily deteriorating market. Financial instruments secured by expected mortgage payments (MBS – mortgage-backed securities) became toxic assets, putting a number of banks at risk of insolvency (Leman Brothers and others went bankrupt).

Between December 2008 and August 2010, the Fed purchased USD 1.25 trillion of MBS, along with purchases of Treasury and Agency instruments. In September 2012, it launched a USD 40 billion monthly mortgage bond purchase program.

The crisis had spread to the rest of the world, where other central banks took identical actions. The ECB also implemented significant quantitative stimulus, buying mostly government debt. Similar actions were implemented by the central banks of Switzerland, England, Japan and others. The total value of assets bought exceeded USD 10 trillion.

The European, as well as other central banks, did not completely end their quantitative stimulus program until the onset of the Covid-19 crisis, at the outbreak of which even greater stimulus was implemented. Undoubtedly, in the future the quantitative easing program will continue to be among the main anti-crisis weapons of central banks.

At the same time, these programs have come in for a lot of criticism.

By its own discretion, the central bank can increase its balance sheet and then inject these funds into the banking system. This is the so-called printed money and is a direct increase in the money supply. Usually, this process creates inflation.

The most significant criticism is that the central bank’s monetary injection does not reach the real economy.

As of 2014, U.S. banks held parked excess reserves of USD 2.7 trillion – a confirmation of the thesis that money does not reach the ultimate beneficiary. This is the main reason why fears of high inflation caused by increased money supply have not come true.

This record was improved with the advent of the Covid-19 crisis, in which excess reserves reached USD 3.2 trillion. In this case, however, the direct monetary injection to households and businesses was substantial, leading to a significant rise in prices (other factors contributed as well).

Forward Guidance

“Forward guidance” is a relatively new monetary policy instrument. The Fed’s goal is to clearly communicate its medium-term plans. This information appears with the FOMC’s post-meeting statement. Particularly since the Global Financial Crisis, the Fed has been constantly modifying this instrument, making it more and more specific.

In the first rate hike since the financial crisis, in December 2015, the FOMC sent several important messages:

“The stance of monetary policy remains accommodative after this increase… The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run”.

It also confirmed its intention to continue its reinvestment policy “…until normalization of the level of the federal funds rate is well under way”.

In this way, the FOMC creates medium-term expectations that monetary policy will continue to be stimulative and that future rate hikes will occur if the economic case is good enough.

In June 2018, the sentence that the federal funds rate was “…likely to remain, for some time, below levels that are expected to prevail in the longer run” was dropped from the statement.

In September of that year, the sentence “the stance of monetary policy remains accommodative”, which had been in effect since 2015, was also dropped.

It is clear that the exclusion of these key phrases indicates the Fed’s intentions for tighter monetary policy.

The “forward guidance” is particularly useful for the financial sector where predictability is of utmost importance.

Conclusion:

The investment community follows central bank actions very closely as they have a direct and indirect impact on the economy and different asset classes.

If, for example, the Fed lowers the federal funds rate, yields on short-term debt instruments are also likely to decline. The change will also be reflected in various banking products such as mortgages, car loans, consumer loans, etc.

If interest rates are expected to remain low in the medium term, a favorable environment for the stock market will be formed.

The Fed’s decisions will have repercussions across the financial sector and, as a final effect, on businesses and households.

The monetary policy tools described above do not exhaust the arsenal of central banks. New tools are constantly coming into use. However, the ultimate objectives remain unchanged.

In addition to monetary policy, central banks perform a number of other key functions. These relate to the stability of the financial and payment system, the regulation of the banking sector, the management of foreign currency reserves, etc.

A number of central banks are following current trends and developing digital currencies.

All these functions and powers make central banks the most important financial institutions in the world.

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