How Central Banks Use Monetary Policy to Manage Economic Cycles
The monetary policy plays a vital role in the economy by regulating the money supply and lending conditions.
Central banks are responsible for executing monetary policy. Typically, these institutions are led by a governor, though their structure and powers vary across central banks. The monetary policy broadly aims to steer the economy through various stages of the economic cycle, focusing on goals such as price stability and optimal employment.
For instance, the U.S. Federal Reserve (Fed) sets monetary policy with a mandate from Congress to promote maximum employment, stable prices, and moderate long-term interest rates. Similarly, the European Central Bank (ECB) prioritizes maintaining price stability as its primary objective.
Central banks make key decisions during regular meetings, and their announcements often create significant market volatility. Through their policies, central banks affect nearly every sector of the economy, from the banking industry to businesses and households.
In fundamental analysis, particular attention is given to central banks overseeing the major currencies: the U.S. Federal Reserve (USD), European Central Bank (EUR), Bank of Japan (JPY), the central banks of Australia (AUD), New Zealand (NZD), Canada (CAD), the U.K. (GBP), and Switzerland (CHF). Among these, the Federal Reserve significantly influences global financial markets, largely because the U.S. dollar serves as the world’s primary reserve currency and is extensively used in international trade.
Although our analysis will primarily focus on Fed, it’s important to note that many other central banks in developed economies follow similar policies.
Monetary Policy Tools
Open Market Operations
Fed buys and sells government and agency securities in the open market daily. This traditional monetary policy tool helps regulate the money supply and adjust interest rates to meet the target levels.
The Federal Open Market Committee (FOMC) sets these targets, and the Federal Reserve Bank of New York executes transactions with primary dealers to fulfill them.
To inject liquidity into the financial system, the Fed purchases government securities, which increases reserves within the banking system. This encourages banks to lend at lower interest rates instead of holding excess reserves.
Conversely, when the Fed seeks to reduce the money supply, it sells government bonds on the open market. This action decreases reserves in the banking system, pushing interest rates higher.
The Central Bank’s Policy Rate
The official interest rate is a vital tool in shaping monetary policy. When the central bank raises this rate, it aims to cool the economy by tightening the money supply and making borrowing more expensive.
A contrasting approach occurred during the Global Financial Crisis (GFC) and the COVID-19 pandemic. In response, central banks sharply lowered interest rates to increase the money supply and make loan products more accessible. Some even implemented negative interest rates, an unprecedented step in monetary policy history.
As a lender of last resort, the central bank sets the interest rate at which commercial banks can borrow from it. This rate is known as the discount rate. When the discount rate changes, commercial banks adjust the interest of their financial products accordingly.
The Federal Funds Rate
In the U.S., investors closely monitor the federal funds rate—an overnight rate for interbank lending. The FOMC sets a target range for this rate (e.g., 1.25% – 1.5%). This target is enforced by adjusting reserve requirements for certain financial institutions, including banks, savings institutions, credit unions, U.S. branches of foreign banks, and government-sponsored entities like Federal Home Loan Banks.
If a financial institution has excess reserves at the end of the day, it will try to lend these reserves overnight to another bank that experiences a reserve shortage. The interest rates for these loans will be close to the target federal funds rate.
When the Fed aims to lower the federal funds rate, it purchases government bonds on the open market. This action injects cash into the banking system, increasing excess reserves. With more liquidity available, banks lower their overnight interest rates to attract borrowers. Conversely, if the Fed wants to raise the federal funds rate, it sells government securities to withdraw cash from the system. This reduces reserves and drives up overnight interest rates.
Essentially, the central bank manages the money supply by adjusting the federal funds rate: raising it to cool down an overheating economy and lowering it to stimulate a slowing economy.
The FOMC meets eight times a year to set the federal funds rate. Additional meetings may be convened in extraordinary circumstances, such as the COVID-19 pandemic.
Reserve Requirements
Banks must keep a specified level of regulatory reserves. When the Fed increases these reserve requirements, banks have less money available for lending, which tightens the money supply. Conversely, reducing reserve requirements allows banks to lend more by freeing additional liquid funds.
To compensate banks for keeping reserves, the Fed pays interest on both required and excess reserves (funds held beyond the regulatory minimum). Adjusting these interest rates serves as an additional monetary policy tool.
In 2019, for example, the ECB implemented negative interest rates on the deposit facility rate to discourage banks from holding excess reserves and encourage them to lend more instead.
Central banks have expanded their range of tools in response to recent economic crises—such as the Global Financial Crisis in 2007 and the COVID-19 pandemic in 2020. In addition to traditional methods like open market operations, interest rates, and reserve requirements, the Fed has introduced quantitative easing and forward guidance to enhance its monetary policy strategy.
Large-Scale Asset Purchases (Quantitative Easing)
Asset purchase programs have become a critical tool for central banks in responding to the Global Financial Crisis and its aftermath. This strategy is especially effective when official interest rates approach zero, making further rate cuts less impactful.
Central banks usually purchase government and mortgage-backed securities (MBS) to inject liquidity into the banking system, thereby influencing the broader economy.
While the specifics of asset purchase programs differ across central banks, they are generally known as “quantitative easing”. For instance, during the GFC, the Fed focused heavily on purchasing MBS, which were at the core of the crisis.
Forward Guidance
“Forward guidance” is a relatively new monetary policy tool the Fed uses to communicate its medium-term plans. This approach is designed to clarify policy direction and appears in statements following each Federal Open Market Committee meeting. Since the GFC, the Fed has refined and specified its forward guidance to provide more precise signals to markets and the public.
For example, with the first interest rate hike after the GFC, in December 2015, the FOMC communicated critical messages in its statement. It reassured markets that “the stance of monetary policy remains accommodative after this increase.” It indicated that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.” The committee also noted that the federal funds rate would likely remain “below levels expected to prevail in the longer run”. Additionally, the FOMC committed to continuing its reinvestment policy until rate normalization was well underway.
These statements set expectations that monetary policy would remain supportive, with future rate hikes occurring only if economic conditions justified them.
By June 2018, however, the forward guidance began to signal a shift. The statement no longer included the phrase that rates would remain “below levels expected to prevail in the longer run.” In September 2018, the phrase that “the stance of monetary policy remains accommodative,” was also removed—indicating the Fed’s intention to tighten policy as the economy strengthened.
Forward guidance is valuable for the financial sector, where predictability is crucial for long-term decision-making. This tool helps manage market expectations and reduces uncertainty by providing a clearer outlook on future policy moves.
A quick look at ECB
The European Central Bank (ECB) operates similarly to other central banks, setting three interest rates:
- Main Refinancing Operations (MRO): This is the rate at which commercial banks can borrow from the ECB for a week.
- Marginal Lending Facility Rate: This is the overnight interest rate for borrowing from the ECB. It is higher than the MRO rate.
- Deposit Facility Rate: This is the overnight interest rate at which banks deposit excess reserves with the ECB.
To encourage lending in the euro area, the ECB lowered the deposit facility rate to -0.5% in 2019. This incentivized banks to offer cheaper loans, as keeping their excess reserves at the ECB would result in a cost rather than earning interest.
Eurozone commercial banks also lend euros to one another short-term (from one week to one year) at rates known as Euribor (Euro Interbank Offered Rate). These rates reflect repo operations between European banks and serve as benchmarks for various financial products. For instance, a eurozone mortgage loan might be offered at Euribor + 3%.
Libor (London Interbank Offered Rate) was traditionally used as the benchmark for short-term interbank loans in the international market. However, Libor is being phased out and replaced by alternatives like the SOFR (Secured Overnight Financing Rate).
Monetary Policy in Action
Let’s explore a hypothetical scenario to analyze the Fed’s monetary decisions and their impact:
Suppose the U.S. economy has been on a solid upward trajectory for several years. GDP and inflation are rising quickly, businesses are highly profitable, production is running at full capacity, unemployment is deficient, and wages are rapidly increasing.
In this situation, the central bank’s primary concern would be the risk of economic overheating. If inflation spirals out of control, the damage to the economy could be severe. To prevent this, the Fed would raise the federal funds rate to curb business and consumer spending. This would be done by restricting the money supply through open market operations. As a result, the overnight interest rate would rise until it aligns with the Fed’s target.
With higher interest rates, commercial banks would offer more expensive loans, discouraging borrowing. Businesses and households would be more inclined to save rather than invest, leading to a slowdown in economic activity and reduced inflation. Unfortunately, this cooling effect often ends in a recession.
Conversely, the Fed would adopt a stimulative interest rate policy when the economy slows and inflation is below the central bank’s target. It would increase the money supply through open-market purchases, encouraging banks to offer more affordable loans instead of holding excess reserves. This would make it easier for businesses and households to finance investments, stimulating economic activity.
The Global Financial Crisis and Fed
The Global Financial Crisis was triggered by the collapse of the housing market, which had been overheated by an oversupply of homes, rapidly rising prices, and increasingly lax lending standards. When the economy slowed and home prices fell, the system unraveled. Many homeowners defaulted on their mortgages, returning their homes to the banks. The banks were then forced to sell these properties in a declining market, further driving down prices.
Mortgage-backed securities, financial instruments tied to mortgage loans, became toxic assets as the expected payments failed to materialize. This threatened the solvency of several major banks, including Lehman Brothers, which ultimately went bankrupt.
In response, the Federal Reserve took unprecedented action, purchasing $1.25 trillion in MBS between December 2008 and August 2010, alongside large-scale purchases of treasury and agency securities. By September 2012, the Fed launched a monthly $40 billion asset purchase program to continue injecting liquidity into the banking system.
The crisis spread globally, prompting other central banks to implement similar measures. The ECB embarked on large-scale quantitative easing, primarily through the purchase of government debt. Central banks in Switzerland, England, Japan, and elsewhere followed suit, with the total value of assets purchased exceeding $10 trillion. When the COVID-19 pandemic struck, central banks responded with even larger stimulus packages.
However, these programs have faced criticism. By expanding their balance sheets and injecting liquidity into the banking system, central banks effectively “print money,” leading to concerns about inflation. Yet, much of the injected capital remained in the banking system rather than reaching the real economy. By 2014, U.S. banks held $2.7 trillion in excess reserves, supporting the argument that the funds were not reaching businesses and households. This explains why fears of runaway inflation did not materialize during and after the GFC.
During the COVID-19 crisis, excess reserves hit $3.2 trillion. However, this time, the direct financial support to households and businesses led to more tangible economic effects, including significant inflation—though other factors also contributed to the increased cost of living.
Conclusion
Central banks are vital to the financial system, as their monetary policies greatly influence the economy and, consequently, the performance of financial assets. Fundamental analysts strive to predict central bank decisions by examining macroeconomic data such as inflation and employment.
For instance, if the Fed reduces the federal funds rate, yields on short-term debt instruments are likely to fall. This rate change also affects various financial products, including mortgages, car loans, and consumer loans.
The Fed’s decisions have far-reaching effects across the financial sector and ultimately impact everyone.
While monetary policy is a central focus for central banks, these institutions also perform other crucial functions, such as ensuring the stability of financial and payment systems, regulating the banking sector, and managing foreign currency reserves. Some central banks are also exploring and developing digital currencies.
These diverse roles and responsibilities underscore the importance of central banks as pivotal financial institutions globally.
