What is a Central Bank and how does it influence markets?

The Central Bank (CB) is the institution responsible for implementing monetary policy in the country. The Central Bank is the only body authorized to issue national currency and regulate monetary and credit circulation. In Ukraine, the Central Bank is the NBU. Let us now consider what exactly they do.

Main functions of the Central Bank

The central bank issues and controls the national currency by regulating the amount of money in circulation. This allows it to influence inflation and overall economic stability in the country.

The Central Bank sets key interest rates, influencing the level of interest rates on loans and deposits. This affects spending, investment and economic activity in general.

The central bank monitors the banking system to ensure its stability and reliability. It sets reserve requirements, conducts bank audits and provides financial support in case of crises.

The Central Bank may intervene in the currency markets to stabilize the exchange rate of its national currency. As an example, from the end of February 2022 to July 2022, the NBU "kept" the official hryvnia exchange rate at around 29.25 +1% in order to slow inflation and stabilize the economic situation in the country.

The role of the US Central Bank in the economy and its impact on global financial markets

The United States Federal Reserve, or simply the Federal Reserve, is the central bank of the United States of America. Few people have not heard of the Fed and their interest rates. Who are they and how do they influence the markets?

Historically, the dollar has been the primary reserve currency in the world economy. Many countries hold reserves in dollars, and global trade transactions are often conducted in this currency. At the same time, the US is one of the world's leading economies. That is why the Fed's policies can significantly affect the value of the dollar and, as a result, the world's financial markets. The world economic machine is like a web in which everything is interconnected. Any changes in the U.S. monetary policy can significantly affect dollar-dependent countries.

What does the Fed do? 

• The U.S. Federal Reserve determines and manages the nation's monetary policy. The Fed regulates interest rates, controls the amount of money in circulation, controls liquidity in the markets by withdrawing or adding to the markets, and strives to maintain price stability and full employment. 
• In addition, the Fed oversees the U.S. banking system, ensuring its stability and reliability. It sets reserve requirements, conducts regular inspections of banks and provides liquidity in times of financial crisis.
• The Federal Reserve is actively involved in responding to financial crises. In appropriate periods, it can lower interest rates, extend credit to financial institutions and introduce other measures to stabilize financial markets.

How does the Fed conduct monetary policy?

Monetary policy is the strategies and measures taken by government institutions to regulate the volume of money supply in order to ensure price stability, maintain economic growth and reduce unemployment. It aims to regulate the money supply and the value of money in order to achieve macroeconomic stability and the Fed's objectives. The Fed implements the monetary policy of a country using several major tools:

• Interest Rates: the Fed sets a target interest rate that serves as a benchmark for interest rates in the market.
• Open Market Operations: The Fed may conduct open market operations by buying or selling government securities.
• Reserve requirements: The Fed sets minimum reserve requirements that banks must hold. Changes in these requirements may affect the availability of borrowed funds and hence the volume of money in circulation.
• Direct impact on interest rates: In addition to the target rate, the Fed may use other tools, such as communication. Official statements, Fed Chair speeches and briefings can influence market expectations and shape the perception of expected Fed policy. That is why economists pay attention not only to press conferences, where the interest rate is announced, but also to the so-called FOMC Meetings.
• Macroprudential measures: The Fed may also introduce macroprudential measures aimed at regulating the financial sector as a whole to prevent systemic risks.

Macroprudential measures are measures and instruments taken by regulators and central banks to ensure the stability of the financial system as a whole. These measures are aimed at preventing or mitigating systemic risks that may arise from the activities of financial institutions. The main objective of macroprudential measures is to prevent crises and minimize their impact on the financial system and the real economy.

Fed interest rates

Federal Reserve (Fed) interest rates have a significant impact on financial markets, and even those far beyond the United States.

The Federal Reserve (Fed) interest rate in the United States is a kind of "base rate" that determines the rate at which commercial banks can borrow money from the Federal Reserve Bank. It is a key tool in the Fed's hands to manage the economy.

High interest rates can curb inflation, but they can also hamper economic growth and make credit more expensive. Low interest rates stimulate the economy but increase the risk of inflation. The Fed's interest rate plays a key role in shaping financial markets, including forex, stock exchanges, the bond market, and even cryptocurrencies. Let's take a look at how interest rates often affect different markets:

• Bond prices: Fed interest rate hikes are often accompanied by declines in bond prices. Bonds issued before the rate hike begin to lose value to bring yields to current interest rate levels.
• Equities: Typically, rising interest rates can hold back stock prices. There are many reasons for this: reluctance to buy, a lack of cash reserves to invest due to the dire economic situation in the country, a shift in focus to exit into the dollar, or investors may prefer the more stable returns of bonds at higher rates.
• Foreign exchange market: rising interest rates may encourage investors to prioritize the dollar by exiting riskier assets. This is done in order to "sit out" the turbulence. The regularity is that the higher the Fed Funds rate, the stronger the dollar, but this is not a rule and in reality, due to additional factors, things may be different.
• Real estate market: higher interest rates may curb activity in the real estate market, as higher rates may make mortgage lending more expensive.

A rise in interest rates could affect overall economic activity by curbing investment and consumption. The Fed uses interest rates to achieve its objectives, including ensuring price stability, maximizing employment, and maintaining the stability of financial markets. Changes in the Fed's interest rates can cause significant reactions in financial markets and shape the overall economy.

The role of the Fed in the 2008 crisis 

After looking at the functions of the Fed and examining what it does, let's look at a real-life example - the 2008 crisis. During the 2008 financial crisis, the U.S. Federal Reserve (Fed) took a number of measures to stabilize the financial system and mitigate the negative effects of the crisis.

Lower interest rates: The Fed quickly lowered the key interest rate in an effort to promote the availability of credit and stimulate the economy. This was done to ease the debt burden on households and businesses, thus they wanted to prevent the crisis from spreading further.

Quantitative Easing (QE) Programs: The Federal Reserve launched several QE programs that involved massive purchases of bonds, mortgage-backed securities, and other financial assets in the market. During QE programs, the U.S. Federal Reserve (Fed) purchases bonds and other assets in the financial markets. This increases demand for these assets, which in turn lowers yields (raises prices) and incentivizes borrowers as interest rates in the market fall. The Fed bought over $1 trillion dollars worth of mortgage-backed securities. This helped stabilize the mortgage market and reduced the risk for the banks that owned these securities.

The Fed is buying mortgage-backed securities

Quantitative Easing (QE) programs are monetary policies in which a central bank increases the money supply by purchasing financial assets on the open market. The purpose of QE is to stimulate the economy, lower interest rates and support growth.

Rescue of Financial Institutions: The Fed has been actively involved in the rescue of key financial institutions by providing financial support and assisting in their financial stabilization. For example, Bank of America received financial support from the Fed in the form of loans and guarantees to strengthen its financial position.

At that time, the Fed was supporting the operation of Bank of America in several ways:

• The Fed provided Bank of America with lines of credit, allowing the bank to obtain additional funds in the crisis and strengthen its liquidity.
• The Fed provided guarantees and insurance for certain Bank of America assets. This action was intended to reduce risk and build confidence in the bank.
• Bank of America also participated in the Troubled Asset Relief Program (TARP), under which the government provided financial assistance to financial institutions.

The Fed's support helped prevent the potential bankruptcy of Bank of America and mitigate the impact of the crisis on the financial system.

Cooperation with other central banks: The Fed cooperated with other global central banks to coordinate efforts to stabilize the global financial system. As the 2008 crisis spread far beyond the U.S. (again proving the impact of the U.S. economy on the world), the Feds decided that it would be better to unite for a common purpose and then get the economy out of the hole.

In general, the Fed's role in the 2008 crisis was to stabilize the financial system, maintain liquidity, and stimulate economic recovery.

However, what did they do to avoid similar crises in the future? After the crisis, the Fed adopted a number of regulatory changes and implemented macroprudential measures to prevent similar crises in the future:

Capital buffers: setting additional capital requirements that banks must maintain in response to economic conditions and systemic risks.

Stress testing: assessing how financial institutions withstand stress scenarios or extreme conditions.

Borrower restrictions: setting limits on the volume of loans or debt levels to prevent excessive lending and risks.

Liquidity constraints: regulating access to short-term financial resources to prevent liquidity crise

Monitoring of systemic financial institutions: enhanced supervision and monitoring of financial institutions that could have a significant impact on the financial system if they collapse.

For example, at the start of the COVID-19 pandemic in 2020, the U.S. Federal Reserve (Fed) took a number of measures to mitigate negative economic impacts. In March 2020, the Fed lowered its key interest rate to near zero between 0-0.25%, which was done to stimulate the economy and make cheap credit available to businesses and households.

These measures had a positive impact on the cryptocurrency markets as well. As a result of these measures, unemployment decreased and the economy started to recover.

In addition, the Fed launched various programs to support financial markets and businesses. One of such programs was the purchase of open market assets, including bonds and other financial instruments, in order to maintain liquidity and stability of the financial system.

The Fed has also taken additional steps to ensure credit availability, including the creation of the Small Business Financing Program (Main Street Lending Program) and the expansion of the Paycheck Protection Program (Paycheck Protection Program).

These steps by the Federal Reserve were aimed at mitigating the negative economic effects of the pandemic, maintaining the stability of the financial system and providing conditions for the recovery of economic activity. These actions of the regulator caused the markets to start their growth.

Who runs the Central Banks?

USA:

The central bank of the United States is the Federal Reserve System. The top management of the Fed is called the Board of Governors of the Federal Reserve System. There are 7 people on the Board, who are appointed by the President of the United States with the consent of the Senate. These people can be in office for 14 years, but by law they cannot be renewed.

Every two years, the president appoints one member of the Board, limited to two (or four for a second term). The chair and vice-chair, chosen by the president from among the seven members, shall lead the Council for a term of four years, with no limit on possible renewals.

The chairman of the US Federal Reserve (Fed) at the moment is Jerome Powell.

He has held the post since February 2018.

European Central Bank (ECB):

The European Central Bank (ECB), like the Fed, is in charge of monetary policy, euro issuance, banking supervision and international monetary relations. The main task of the ECB is to maintain price stability in the Eurozone. The leadership of the European Central Bank (ECB) currently consists of six members, including the President and Vice-President. Nominations for these positions are proposed by the Governing Council, subject to approval by the European Parliament and the euro area leaders. This process provides broad legitimacy and consistency in the formation of the ECB leadership. The current President of the ECB is Christine Lagarde.

She has been in office since 2019.

People's Bank of China (PBOC):

The People's Bank of China (PBOC) is the central bank of China and performs a number of key functions in the economic and financial sphere of the country. It is involved in monetary policy, issuance of national currency, financial supervision, foreign exchange reserve management and international financial relations.

The governor of the People's Bank of China (PBOC) is appointed by the Congress of the Chinese People's Congress. This is a powerful position in China, and elections are held every five years along with the formation of a new Chinese People's Congress. The election process begins with the nomination of candidates and then the delegates of the Chinese People's Congress vote for the head of the People's Bank of China. Currently, the head of the People's Bank of China is Pan Gongshen.

He has been in office since July 2023.

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Traders, investors, funds and other market participants closely monitor the actions of the Central Bank and the country's monetary policy. The correct interpretation of the actions of the Central Bank provides an improved understanding of the current market situation and the ability to predict future market movements.

It is important to understand that for the most part we are talking about medium- and long-term expectations, but we must not forget about intraday trading, because understanding the actions of the Central Bank can help more accurately determine local market movements, taking into account the publication and forecasting of important macroeconomic data indicators, based on which The Central Bank makes its decisions.