Understanding the Monetary Policy Tools that Central Banks have at their Disposal

The actions taken by Central Banks globally have kept us all on edge this year as they attempt to address multiple issues that have arisen. The Fed, BOE, and the ECB, like other Central Banks, have multiple tools to perform their job and achieve their goals. Their objective is to regulate inflation and unemployment, and maintain currency exchange rates.

Adjusting interest rates is probably the most well-known tool these have. But what other tools do Central Banks possess? What methods can they use to implement their mandate? The purpose of this blog is to try to shed some light on the monetary policy tools that Central banks have at their disposal.

Monetary policy tools can be subdivided into traditional and non-traditional, or unconventional tools. Traditional tools include setting bank reserve requirements, open market operations, and the adjustment of interest rates. Non-traditional tools may include quantitative easing, negative interest rates, collateral adjustments, and forward guidance. We will review these next.

Bank reserve requirements

Reserve requirements refer to the proportion of cash reserves that a bank must keep on hand, and it is dictated by Central Banks as a result of their monetary policy. What does this mean?

Savers deposit funds in banks. Banks then lend these funds in exchange for interest payments, generating an income. If there were no reserve requirements, then banks would be able to lend out all the deposits. Savers, in turn, would become increasingly wary of depositing funds out of fear of not being able to withdraw them back from the bank in a time of emergency or liquidity crisis. Why? If banks did not keep reserves, they would likely not have enough liquidity to give back the funds to the savers.

Since banks need to be able to provide customers with access to their funds, banks are required to maintain a portion of the deposits readily available. Central Banks are thus able to dictate how much money is available for depository institutions to lend, regulating lending activity.

Open Market Operations

Another monetary policy tool Central Banks utilize is open market operations (OMOs). OMOs are the purchase and sale of securities by a central bank in the open market. Central Banks can use OMOs to adjust the amount of money and credit in the economy and affect other economic factors such as unemployment and output. Through OMOs, the Fed, for example, can regulate the fed’s funds rate, which in turn will influence other rates.

Interest Rates

The discount rate or base rate is the interest rate charged by a central bank to financial institutions for short-term loans. Central Banks can affect interest rates by adjusting the discount rate. If the Fed increases the discount rate, then the cost of borrowing for financial institutions like banks increases, and in turn, these will increase the interest rates they charge to their customers when lending. Increasing the discount rate increases the economy’s cost of borrowing, causing a decrease in the money supply.

Quantitative Easing (QE)

When short-term interest rates are at zero or close to zero, and the economy still needs some stimulus, the Central Banks can do something else rather than to keep on cutting rates. Central Banks can opt to purchase other types of securities than just government bonds. Doing so increases the money supply without further decreasing rates. When this happens, financial institutions can raise more capital, which promotes lending and liquidity.

Negative Interest Rates

Negative interest rates were adopted in Europe and Japan after Central Banks decided they needed to make a drastic measure in order to prop up their struggling economies after the 2008 Crisis. So, they implemented negative interest rates. It has been considered one of the boldest nontraditional expansionary monetary policy experiments of the 21st century.

What exactly happens during a negative interest rate environment? It is an upside-down approach to positive interest rates. Technically when this policy is implemented, Central Banks charge commercial banks an interest rate on their deposits. Negative interest rates are aimed at stimulating commercial bank spending and commercial bank lending. A negative interest rate environment is not a friendly environment for commercial banks to store their cash reserves as they will lose value due to the interest rate.

Forward Guidance

Another form of nontraditional monetary policy is forward guidance. Essentially this is the process by which a Central Bank will share information about its intentions regarding monetary policy with the public. Forward guidance will have an impact on current economic conditions. The public is always looking for hints within remarks made by Central Banks. Note, with forward guidance Central Banks can either solidify or lose the market’s confidence.

Central Banks, all have a variety of tools that they utilize to conduct monetary policy. These tools can fall into the traditional and non-traditional monetary policy tool buckets. Central Banks will utilize a combination of these to try to achieve their goals, whether it is to stimulate the economy or not. For the utmost clarity, we only reviewed some of the most popular tools in this blog, but there are more.

Sources:
Investopedia, August 2022. “Non-Standard Monetary Policy”
Wall Street Prep. “Reserve Requirements”
Federal Reserve, September 2022. “Policy Tools”
Investopedia, September 2022. “What are Open Market Operations (OMOs), and How Do They Work”
Corporate Finance Institute, May 2022. “ Monetary Policy”