Central banks and what they actually do

Central banks are the most watched institutions in financial markets, and what they actually do is narrower and more specific than the coverage suggests.

The mandate

Which determines everything else.

Most central banks in developed economies have a primary mandate of price stability, generally expressed as an inflation target.

Some have a dual mandate including employment.

Some have additional objectives regarding financial stability.

Independence from government in setting policy is the norm in developed economies, established on the basis that politically controlled monetary policy produced worse inflation outcomes.

Which means the institution is constrained by its mandate rather than free to pursue whatever seems desirable.

The main tool

Interest rates.

Setting a policy rate that influences rates throughout the economy.

Raised to reduce demand and lower inflation; lowered to do the reverse.

Operating with a substantial lag, commonly estimated at a year or more before the full effect on inflation.

Which means policy is always set for conditions that will exist later, based on projections that are frequently wrong.

Quantitative easing and tightening

The tool used when rates approach their lower bound.

Purchasing government and sometimes corporate bonds, which raises their prices and lowers yields, and increases reserves in the banking system.

The intended effects: lower long-term borrowing costs, portfolio rebalancing towards riskier assets, and signalling about future policy.

Its effectiveness is debated, and its effects on asset prices and wealth distribution have been substantial and contested.

Quantitative tightening reverses it, through allowing holdings to mature or selling them, which withdraws liquidity.

Communication

Which frequently matters more than the decision.

Forward guidance about the likely path of policy affects market expectations, which affects rates throughout the economy immediately.

Which means a decision that is fully expected produces little reaction while an unexpected change in guidance produces a large one.

Published projections, meeting minutes and speeches are all parsed for signals.

And the credibility of the institution — whether markets believe it will act as stated — is itself a policy tool.

What they do not control

Which is substantial.

Supply shocks: energy prices, supply chain disruption and commodity movements, which affect inflation and are not responsive to interest rates.

Fiscal policy, which is a government decision.

Structural factors affecting growth and productivity.

And the specific distribution of the effects of their policy, which falls unevenly.

Which means criticism of central banks for outcomes outside their tools is common and frequently misdirected.

The financial stability role

A separate function.

Acting as lender of last resort to solvent institutions facing liquidity problems.

Supervising banks in many jurisdictions, or working alongside a separate supervisor.

Setting capital and liquidity requirements.

Conducting stress tests.

And intervening during market dysfunction, as has occurred during several recent episodes.

This function sometimes conflicts with the inflation mandate, which produces genuinely difficult decisions.

What markets react to

Specifically.

Differences between the decision and what was expected.

Changes in guidance about the future path.

Changes in projections.

Shifts in the balance of opinion within the committee.

And the tone of communication, which is parsed closely.

Which means the level of rates matters less than the change in expectations about future rates.

What it means for an individual

Practically.

Mortgage and savings rates follow policy rates with varying speed depending on the product and the market.

Which means knowing when a fixed rate ends matters more than following policy meetings.

Bond values move with rate expectations, which affects any bond holding.

Currency moves with relative rate expectations.

And equity valuations are affected through discount rates, particularly for companies with earnings expected far in the future.

None of which is actionable in advance, since expectations are already priced.

The forecasting caution

Worth including.

Central banks publish their own projections, which are revised substantially and frequently.

Market pricing of future rates has repeatedly proved a poor predictor of the actual path.

Which means that positioning a portfolio for a specific rate path is a forecast with the same poor record as any other.

And that the appropriate response is a portfolio robust to a range of outcomes rather than one optimised for a predicted path.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.