Central Banking 101

1. The modern financial system is built on four types of money

Look in your wallet and think about your day—how much currency do you carry and use?

Four types of money. The modern financial system relies on four main types of money:

1. Central bank reserves: Special money issued by the Federal Reserve, only held by commercial banks
2. Bank deposits: Created by commercial banks, the primary form of money used by the public
3. Treasuries: Government-issued securities that function as interest-bearing money
4. Fiat currency: Physical cash issued by the government

These forms of money are interconnected and freely convertible in a functional financial system. Bank deposits, the most common form for the public, are essentially IOUs from banks, while central bank reserves are IOUs from the Federal Reserve to commercial banks. Treasuries serve as a form of money for large investors, offering a safe store of value with interest.

2. Commercial banks and shadow banks create most of the money in circulation

A commercial bank is a special type of business that holds a license from the government to create money.

Money creation process. Commercial banks create money when they make loans or buy assets, contrary to the common misconception that they lend out existing deposits. This process increases the money supply without directly involving the central bank. Shadow banks, which are non-bank financial institutions, also engage in banking-like activities and create money-like instruments.

Commercial bank money creation:

• Make a loan or purchase an asset
• Create a corresponding deposit in the borrower's account
• New money enters circulation when the borrower spends the loan

Shadow bank money creation:

• Borrow short-term to invest in longer-term assets
• Create money-like instruments (e.g., money market fund shares)
• Increase liquidity in the financial system

The ability of banks to create money is limited by profitability considerations and regulations, such as capital requirements and reserve ratios.

3. The global financial system relies heavily on the U.S. dollar

Eurodollars are U.S. dollars held outside of the United States.

Dollar dominance. The U.S. dollar plays a central role in the global financial system, extending far beyond U.S. borders. This dominance is evident in:

1. International trade: About 50% of global trade is invoiced in dollars
2. Foreign exchange reserves: Approximately 60% of global foreign exchange reserves are held in dollars
3. Offshore dollar market: A vast market for dollar-denominated transactions outside the U.S.

The widespread use of the dollar gives the U.S. significant economic and geopolitical power. It allows the U.S. to impose effective sanctions by cutting off access to the dollar financial system. However, this also means that Federal Reserve policies have far-reaching global implications, effectively making it the world's central bank during crises.

4. The Federal Reserve controls short-term interest rates and influences long-term rates

The Fed controls short-term interest rates through its control over overnight interest rates.

Fed's interest rate tools. The Federal Reserve uses several tools to manage interest rates:

Short-term rate control:

• Federal funds rate target
• Interest on excess reserves
• Overnight reverse repo facility

Long-term rate influence:

• Forward guidance
• Quantitative easing
• Yield curve control (potential future tool)

The Fed's control over short-term rates allows it to influence longer-term rates, as market participants use the overnight rate as a reference for pricing longer-term loans. However, long-term rates are also affected by market expectations of future economic conditions and inflation.

5. Capital markets allow for efficient allocation of existing money

Rather than create more bank deposit money, the debt capital markets allow a more efficient use of existing bank deposit money.

Capital market functions. Capital markets, comprising equity and debt markets, serve crucial functions in the financial system:

1. Efficient allocation: Allow holders of bank deposits to lend directly to non-bank borrowers
2. Price discovery: Provide information about the value of assets and companies
3. Risk transfer: Enable investors to diversify their portfolios and hedge risks

Equity markets:

• Public markets: Stocks traded on exchanges
• Private equity: Investments in non-publicly traded companies

Debt markets:

• Corporate bonds
• Government securities
• Mortgage-backed securities

Capital markets complement the banking system by providing alternative funding sources and investment opportunities, contributing to overall financial system efficiency.

6. Financial crises often stem from breakdowns in money markets

When money markets break down, those entities cannot roll over their short-term debt and are forced to sell their assets to repay loans.

Crisis dynamics. Money markets, which facilitate short-term borrowing and lending, are crucial for the day-to-day functioning of the financial system. Breakdowns in these markets can quickly lead to broader financial crises:

1. Liquidity squeeze: Lenders become unwilling to roll over short-term loans
2. Forced asset sales: Borrowers must sell assets to repay loans, often at fire-sale prices
3. Contagion: Price declines in one asset class spread to others, creating a negative feedback loop

Examples of money market breakdowns leading to crises include:

• 2008 Financial Crisis: Repo market and interbank lending market freezes
• 2020 COVID-19 panic: Stress in commercial paper and municipal bond markets

These events highlight the importance of well-functioning money markets for financial stability.

7. The Federal Reserve has expanded its role as lender of last resort

The Fed met the crisis by vastly expanding its lending counterparties to include key shadow banking sectors.

Expanded Fed support. Since the 2008 Financial Crisis, the Federal Reserve has significantly broadened its role as lender of last resort:

Traditional role:

• Lending to commercial banks through the discount window

Expanded role:

• Support for shadow banks (e.g., primary dealers, money market funds)
• Lending to foreign central banks through swap lines
• Direct support for businesses and specific markets (e.g., corporate bond purchases)

This expansion reflects the changing nature of the financial system, where non-bank entities play an increasingly important role. By providing liquidity to a broader range of institutions, the Fed aims to maintain financial stability and prevent systemic crises. However, this expanded role also raises questions about moral hazard and the appropriate limits of central bank intervention.

8. Central bank communication is crucial for guiding market expectations

Remember, the modern era Fed doesn't want to surprise the market too much because it does not like volatility in financial asset prices.

Fed communication channels. The Federal Reserve uses various communication tools to guide market expectations and implement monetary policy:

1. FOMC statements
2. Press conferences
3. Minutes of FOMC meetings
4. Economic projections ("dot plot")
5. Speeches by Fed officials
6. Congressional testimonies

Effective communication helps the Fed:

• Manage market expectations
• Reduce financial market volatility
• Enhance policy effectiveness

By clearly articulating its views on the economy and future policy actions, the Fed can influence long-term interest rates and financial conditions without necessarily changing its policy rate.

9. Quantitative easing and forward guidance are now standard monetary policy tools

Both forward guidance and quantitative easing have moved from unconventional to conventional parts of the Fed's toolkit after over a decade of use.

New monetary policy tools. In response to the challenges of the zero lower bound on interest rates, central banks have adopted new policy tools:

Quantitative easing (QE):

• Large-scale asset purchases, primarily of government bonds
• Aims to lower long-term interest rates and increase money supply

Forward guidance:

• Explicit communication about future policy intentions
• Can be time-based or outcome-based

These tools allow central banks to influence financial conditions and stimulate the economy even when short-term interest rates are near zero. While initially controversial, they have become standard practice for major central banks worldwide.

10. The effectiveness of lowering interest rates to stimulate economic growth is debatable

Even without the Fed, interest rates would still follow the business cycle.

Interest rates and growth. The relationship between interest rates and economic growth is complex and potentially misunderstood:

Conventional wisdom:

• Lower rates stimulate borrowing and spending
• Higher rates cool down an overheating economy

Counterarguments:

• Interest rates and growth are positively correlated in historical data
• Ultra-low rates may have diminishing returns or negative effects

Potential issues with low rates:

• Reduced bank profitability
• Asset price inflation without corresponding economic growth
• Encouragement of excessive risk-taking

While lowering interest rates remains a primary tool for central banks, its effectiveness in stimulating real economic growth, particularly in a low-rate environment, is increasingly questioned. This has led to debates about the need for alternative policy approaches, such as fiscal stimulus or structural reforms.

Last updated: November 2, 2024