A central bank is a public institution that controls the money supply in a country. Typically, it is mandated by the country’s national government to target low inflation, that is, to curb the general rise in the prices of goods and services across the economy that erodes purchasing power for consumers and businesses. Inflation hits you and me directly in the pocket when the cost of our weekly grocery bill rises or the price display on the petrol station spins faster than it used to. We lose confidence in our ability to spend and save, leading to a risk that the economy will weaken.
Central banks essentially act as pilots of the economy by smoothing out any inflationary turbulence so that consumers and businesses feel relaxed about spending, saving and investing en route to their desired financial destinations. The aim is that, in doing so, they ensure a flourishing economy overall.
How do Central Banks control the economy?
The primary method central banks use to achieve this is by increasing or decreasing short-term interest rates, or the ‘price of money’. The higher the interest rate, the more attractive it is to save money and the less attractive it is to borrow money in the short term. When central banks raise the interest rate, goods and services become more expensive, and the economy slows down.
But this isn’t the only tool at their disposal. Central banks can also influence interest rates by steering the money supply, for example, by buying or selling securities to inject money into, or remove money from, the banking system. Alternatively, they can set the percentage of deposits that commercial banks hold as reserves. When these reserve requirements are higher, it restricts the amount of money that banks can lend and thus affect interest rates.
What does this mean for investors?
Whether central banks choose to accelerate or decelerate the pace of the economy by manipulating the interest rate, it has important consequences for consumers and investors, in terms of how they allocate their spending and investments. When a central bank raises interest rates, for example, the cost of a loan increases for consumers. In particular, it typically leads to a rise in the mortgage rate, thereby increasing costs for homeowners with variable-rate mortgages.
For investors, the precise impact of the interest rate change depends on the particular asset class. In the case of equities, for example, when wages are high and the underlying economy is strong, consumers can afford to buy a company’s products. Companies enjoy rising profits and shareholders should receive a greater return on their investment. Conversely, when the economy is weak, consumers can’t afford to buy goods and services and company profits fall, decreasing the potential returns to shareholders. With fixed income, on the other hand, investors can lend money to the issuer – usually a large company or government, at a fixed rate of interest. Therefore, when inflation is high, investors effectively receive less income. What’s more, the underlying value of the investment is also eroded by inflation.
What about cash or savings?
When central banks increase interest rates to combat inflation, they’re encouraging investors to hold more of our assets in savings. Unfortunately, however, they won’t raise their interest rates above inflation, so the real interest rate investors are exposed to will always be negative. For example, if your bank pays you 2% interest on your savings, but inflation is 3%, the real interest rate for your savings is -1%, which means your purchasing power will decrease by 1% per year.
Why is the Federal Reserve so important even for those outside the US?
There’s no such thing as a global central bank, but the US Federal Reserve is the closest thing to it. Why? On the one hand, the US dollar enjoys a unique status as the world’s main reserve currency, with no signs of that changing any time soon. Secondly, the vast majority of global trade in goods and services continues to be conducted in US dollars. The ‘greenback’ retains a clear dominance on global foreign exchange markets and the US dollar dominates the reserve holdings of most central banks. As a result, the Fed’s decisions reverberate throughout the global economy, and its policies constitute one of the most important variables you must take into account when making investment decisions.
Regardless of which monetary policies central banks like the Fed and others are currently pursuing, you will be better positioned to weather the changes with a diversified portfolio, owning assets that outpace inflation and take advantage of the prevailing interest rate environment.
