- Central Banks analyze a myriad of economic data and forecasts before formulating policy.
- These data points are subsequently integrated into the central bank's operational framework to ascertain the necessity of a policy shift.
- To actually implement policy changes, central banks rely on their execution divisions, which engage in financial market transactions to enact the desired policies.
HOW CENTRAL BANKS SET POLICY
Monetary authorities play a pivotal role in influencing financial markets. Central bank officials gather, assess, and interpret economic data to chart the future trajectory of the economy, aligning it with the bank's policy objectives. When confronted with challenges or deviations from the desired economic path, central banks often take decisive policy actions. However, the formulation of central bank policy is not a straightforward process, limited to issuing press statements announcing changes in interest rates, adjustments to asset purchases, or additional supportive measures. These policies must be executed through transactions within financial markets.
Central bank policies have a direct and sometimes immediate impact on foreign exchange (FX) markets. As central banks loosen or tighten their policies, their respective currencies become more or less appealing to investors. Grasping the mechanism behind central bank decisions is a crucial skill for traders, as it allows them to anticipate potential actions, thereby gaining deeper insights into each pivotal economic data release.
MANDATES AND PRICE STABILITY
While the US Federal Reserve holds a significant position as the preeminent and essential central bank, its mission goes beyond that of the typical central bank. The Federal Reserve's objectives encompass both maximum employment and price stability, while most other central banks concentrate solely on ensuring price stability. Price stability is accurately described as maintaining low, consistent, and foreseeable inflation rates. The majority of central banks aim for an inflation level of approximately 2%, which is considered a reliable gauge of robust and steady economic expansion. When devising monetary policy measures, central banks must carefully consider a variety of distinctive economic indicators, expectations, and prevailing conditions.
ECONOMIC DATA
Central banks meticulously analyze the identical economic information that FX traders and other market participants closely observe. Joblessness, housing, and inflation are among the pivotal data points that central bankers monitor as they convene to deliberate and establish policy. These markers hold significance in GDP and in discerning burgeoning or decelerating patterns in a vast economy.
PROJECTIONS, ECONOMISTS
Beyond the conventional monitoring of economic data available to market participants, central banks rely on an extensive cadre of specialized economists who are regarded as leaders in their respective fields. These experts shoulder the responsibility of crafting projections that shape the central bank's policies. By skillfully crafting and modeling economic forecasts based on present data, future expectations, subject matter expertise, and plausible policy options, economists provide vital insights into the future trajectory of the economy.
Central bankers utilize these sophisticated models to foresee the economy's direction and to assess the potential repercussions of policy decisions. Many central banks regularly release digests of their economic and policy projections, which serve as a valuable tool for traders seeking to comprehend how influential market drivers perceive the overall economic landscape.
FRAMEWORKS
Upon gathering requisite economic data and projections, central banks apply them to assess whether policy changes are necessary. Their policy framework outlines the correlation between key economic metrics and the central bank's mandate, specifically how various economic data points impact inflation.
The global economy's constant evolution has prompted ongoing changes to central bank policy frameworks. In the past, monetary policy relied on simple rules and equations to determine appropriate interest rates based on inflation and employment levels. However, as the world became more complex, central banks moved away from this simplistic, rules-based approach to policy.
The most significant development with far-reaching implications for central bank policy is the persistent trend of low interest rates and low inflation in developed economies. Prolonged low interest rates have limited the central bank's ability to combat economic downturns solely through interest rate cuts. Moreover, the persistence of low inflation despite tight labor markets and low rates has forced central banks to reevaluate and update their understanding of the relationship between employment and inflation.
Given these shifting dynamics, the Federal Reserve and the European Central Bank (ECB) both conducted reviews of their monetary policy frameworks. The ECB's review and conclusions are still ongoing, but the Federal Reserve revealed its findings and new policy framework in the late summer of 2020. In this announcement, Fed central bankers acknowledged that the connection between inflation and employment had changed, allowing the economy to withstand higher employment levels without triggering inflation. The Fed also shifted its inflation policy from a symmetric 2% target to an average 2% target, implying that they will tolerate inflation higher than 2% to balance the average. Essentially, this new framework indicates that the Fed will no longer tighten policy at the first signs of overheating but instead allow the economy to continue expanding.
This departure from the post-financial crisis framework is crucial for traders and market participants. Understanding that higher inflation and robust economic data won't lead the Fed to preemptively tighten policy helps inform trading decisions. For central bank watchers and traders in general, comprehending the central bank's framework is of utmost importance. It enables more informed trades by predicting the market's expectations following data releases.
Once the central bank aligns new economic data and projections with its framework, it makes a decision. While decisions once centered on raising or lowering interest rates, central bank toolkits have significantly expanded since the financial crisis, with central banks playing a larger role in supporting the financial system and the overall economy.
CONVENTIONAL VS UNCOVENTIONAL POLICY TOOLS
Before the financial crisis, most central banks had a relatively standard toolkit, using short-term interest rates and reserve requirements to control bank lending. The Bank of Japan was an exception, using unconventional tools to combat recession and deflation in the late 1990s.
In the aftermath of the financial crisis, global central banks, led by the Federal Reserve, adopted similar unconventional policies like buying government bonds and setting policy rates at zero or even negative. They also created targeted tools to support specific areas of the financial system that were not covered by traditional measures.
These unconventional tools have become a crucial part of the central bank's toolkit and have been effectively used during the Covid crisis. In addition to cutting policy rates to the zero-lower bound, central banks expanded their support measures, including pledging assistance to corporate bond markets, backstopping critical areas of the financial system, and buying trillions in government bonds.
QUANTITATIVE EASING
Following the financial crisis, central banks embarked on a journey to manipulate longer-term rates and inject the financial system with liquidity to bolster economic spending, growth, and inflation. This involved implementing large-scale asset purchase programs, commonly known as quantitative easing (QE), where central banks bought substantial amounts of government debt from the open market. While the exact workings of QE remain a subject of debate, these initiatives aimed to drive down longer-term interest rates, support inflation, and provide a boost to various financial markets.
The significance of QE has grown due to the extended period of low interest rates experienced by advanced economies. As traditional rate cuts became insufficient in jumpstarting the economy during a recession, central banks turned to additional QE programs. Research indicates that an asset purchase program equivalent to approximately 1.5% of GDP has a comparable impact to a 25 basis point interest rate cut. Given that pre-Covid US interest rates were merely 1.50%, and rates elsewhere were even lower, continued QE programs were seen as necessary to complement the shortfall in conventional rate cuts. Consequently, asset purchase programs have expanded significantly since the Covid crisis commenced, leading to central bank balance sheets reaching unprecedented levels.
IMPLEMENTATION
These unorthodox assistance measures are executed by the central bank's monetary policy execution unit. The execution unit is where central bank policy is effectively implemented via transactions and specialized modifications made in financial markets. Policy determinations from chief central bankers are conveyed to central bank traders, who subsequently engage in dealings with specific counterparties to adjust rates or otherwise execute policy resolutions.
RATE SETTING: PRE-CRISIS
Pre-crisis, the Federal Reserve's monetary policy involved the implementation of decisions through the Federal Reserve Bank of New York. Traders on the markets desk would conduct open market operations with primary dealers, who are large banks approved as trading counterparts of the NY Fed. These dealers were required to support the issuance of US Government debt (Treasuries) and make markets. The NY Fed markets desk would buy or sell Treasuries from these banks, adjusting the liquidity supply in the financial system and influencing short-term rates to align with the desired range set by the FOMC. This method of fine-tuning liquidity was used by central banks globally before the unconventional tools of the financial crisis were employed.
RATE SETTING: POST-CRISIS
Post-crisis, the impact of traditional open market operations on liquidity and credit conditions diminished significantly due to the quantitative easing (QE) operations undertaken by central banks. The Fed's primary policy lever became the interest rate on reserves, which determined the rate at which banks earned for storing QE-generated money directly with the Fed.
The Federal Funds Market saw a drastic reduction in activity as banks no longer needed to seek funds to meet regulatory requirements or lend to other banks on an unsecured basis. Instead, interbank lending shifted to the repo market, where loans are secured against collateral. The NY Fed's repo and reverse repo facilities became crucial tools for managing excess liquidity in the system. The rates on these facilities were frequently adjusted alongside the Fed's main policy rate. The repo (RP) facility enabled the Fed to lend to market participants seeking cash against Treasury collateral, establishing an upper bound on interest rates. Conversely, the reverse repo facility (RRP) involved the Fed lending Treasury collateral to market participants with excess cash, acting as a temporary drain of reserves from the system and establishing a lower bound on interest rates.
During the period from 2014 to 2018, prior to the Covid pandemic, the Federal Reserve's balance sheet experienced a peak. The RRP (Reverse Repurchase Agreement) facility witnessed significant utilization during quarter-end periods. This occurred as excess cash was withdrawn from other parts of the financial system to prevent interest rates from falling below the lower-end target set by the Federal Open Market Committee (FOMC).
Given the current post-Covid environment with bank reserves reaching new record highs, one would anticipate observing a similarly substantial usage of the RRP facility during future quarter-ends. In preparation for this potential increase in demand, the New York Federal Reserve raised the counterparty limit for the RRP facility during the March 2021 FOMC meeting.
UNCONVENTIONAL POLICY IMPLEMENTATION
Quantitative Easing (QE) initiatives are executed similarly to open market operations. Central bank traders, within the policy implementation division, release notifications and timetables outlining their purchase intentions. Counterparties then submit a roster of bonds they are eager to vend to the central bank, and the bank's traders proceed to engage in transactions with the most competitive bids. While the internet abounds with central bank-focused memes related to money printing, the actual currency generated by the central bank, in exchange for these bonds, is purely digital. The accounts of the participating counterparties are credited with newly minted digital funds from the central bank.
COMMUNICATION IS KEY
In light of the evolution of monetary policy post-financial crisis, forward guidance has emerged as a crucial tool in the central bank's toolkit. It involves communicating the future trajectory of interest rates to businesses, investors, and markets, allowing them to better predict the central bank's actions. The goal is to adjust expectations and provide clarity to the financial markets. Transparency and communication play a vital role in maintaining the central bank's predictability and credibility, given its significant influence over the financial system.
The Forward Guidance strategy began with the FOMC during the financial crisis, initially indicating that interest rates would be kept at zero "for some time." As the economy recovered, forward guidance evolved into a dates-based approach and later into an outcomes-based approach. These methods effectively set long-term policy expectations and have been employed successfully by central banks worldwide.
Amid the Covid crisis, central banks once again turned to forward guidance, issuing clear communications about rate outlooks, tapering expectations, and asset purchase program paths. The Federal Reserve has adhered to guidance consistent with its new framework, even in the face of strong economic data and market concerns about inflation. FOMC members have emphasized that tapering and rate hikes will only occur once significant progress is made toward the Fed's objectives.
SETTING POLICY, SUMMATION
Central bank policy has undergone significant transformation during the past two decades. Although the data central banks use to shape policy has remained relatively stable, the implementation of such policy has experienced substantial changes. The emergence of secular trends after the financial crisis has necessitated novel policy innovations. Presently, central banks govern interest rates and monetary policy primarily by managing liquidity, engaging in extensive asset purchases, making technical adjustments to money markets, and improving communication. Grasping the intricate connections and influences among these elements and their consequences for overall financial markets provides invaluable insights for traders.
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