The role of central banks

Not every country has a central bank but the majority of countries do. Central banks issue and regulate the national currency, control monetary policy, and often act as a lender of last resort. The few countries and territories that do not have their own central banks may use the currency of another country or rely on other financial institutions for these functions.

The U.S. Federal Reserve (the Fed) is one of the most powerful central banks in the world. The European Central Bank (the ECB) oversees the policies of the eurozone. Other notable central banks include the Bank of England (BoE), the Bank of Japan (BoJ), the Swiss National Bank, the Bank of Canada, and the Reserve Banks of Australia and New Zealand. These banks are all deemed to be independent.

The People's Bank of China (PBOC) is China's central bank. Founded in 1948, it also manages the nation's monetary policy and financial stability, serving as the exclusive issuer of the Chinese yuan. It also oversees foreign exchange reserves. Though operating with some degree of autonomy, the PBOC lacks central bank independence and is required to implement the policies of the Chinese Communist Party (CCP).

Independence

Before independence, central banks were effectively an arm of their respective governments. The idea of having a fully independent central bank was discussed by economist Milton Friedman in 1962, who dismissed it on the grounds that it wouldn't survive the first real conflict with government. The Federal Reserve, however, has enjoyed operational independence since 1951 and this approach gained momentum in the 1980s and took off in the 1990s, when many central banks, including the Bank of England, were reformed and more were created in what used to be the Eastern Bloc.

The Bank of England was made independent in 1997 by Gordon Brown as the New Labour government under Tony Blair came to power. A central bank is deemed independent if it can make policy without interference from elected officials or the private sector. The main idea is that governments could lean on the central bank to engineer a boom when they need re-election and stop rate hikes that would be too painful for their voters. This would cause the economy to overheat and inflation to run too high until an inevitable bust. Instead, central banks now mainly focus on inflation, sometimes married with another goal such as full employment, and let politicians deal with questions of redistribution and fairness i.e. fiscal policy.

Most central banks in the developed world and many in emerging economies are now formally independent, albeit to varying degrees. In practice, the line between central banks and governments can get blurry and is in some cases little more than a polite fiction. For example, Turkey's central bank is formally independent but that hasn't stopped the country's government from sacking governor after governor if they didn't grant their wishes. Even in the United States and Europe, central bankers are routinely accused of bankrolling states with massive purchases of government debt, which have become common, particularly since the global financial crisis. While these 'quantitative easing' programmes were regularly justified with the need at the time to boost inflation when it was too low, they placed central banks working shoulder to shoulder, rather than at arm's length, with their governments. This is nowhere more visible than in Japan, where the central bank now owns half of the government's debt.

Central banks’ decisions can have a significant impact on a nation’s economy and financial markets.

The key functions of central banks, which may vary slightly from one country to another, typically include:

• Monetary Policy - formulating and implementing monetary policy to achieve economic goals. They adjust interest rates, open market operations, and reserve requirements to control the money supply and influence inflation, employment, and overall economic growth.
• Currency - issuing and regulating the country’s currency. They ensure the availability of physical cash and maintain the integrity of banknotes and coins.
• Banker to the Government - Central banks often act as the government’s banker, processing government transactions and managing public debt.
• Lender of Last Resort - in times of financial crisis, central banks provide emergency funding to banks and financial institutions to prevent widespread collapses, maintaining financial stability.
• Supervision and Regulation - overseeing and regulating banks and financial institutions to ensure they operate safely and soundly. This helps protect depositors and maintain the stability of the financial system.
• Foreign Exchange Management - managing a country’s foreign exchange reserves, intervening in foreign exchange markets to stabilise exchange rates.
• Economic Research and Analysis - conducting economic research, collecting data and providing analysis to guide policy decisions.
• Payment System Oversight - overseeing and facilitating the smooth operation of payment systems, ensuring the efficient transfer of funds and settlement of transactions.
• Financial Stability - monitoring and addressing systemic risks within the financial system, working to prevent and mitigate financial crises.

Central banks play a vital role in the overall economic and financial stability of a country and their actions have far-reaching impacts on businesses and individuals. With inflation spiking in so many regions since the pandemic, then fuelled by supply chain issues followed by the subsequent war in Ukraine, it’s no wonder that central banks have been at the centre of so much attention once again.

Although every effort has been made to ensure that the information provided in this article is accurate and correct, the information provided does not constitute any form of financial advice. We recommend that you take financial advice before making any financial decisions.