The Role of Central banks and how they implement monetary policy

The Role of Central banks and how they implement monetary policy On 15 May 2024, The Monetary Policy Rate (“MPR”) was raised by one hundred (100) basis points (“bps”) to 13.5% by Zambia’s central bank, the Bank of Zambia (“BOZ”) as decided by the Monetary Policy Committee (“MPC”) at its Meeting held from May 13 - 14, 2024. Basis points are a unit measure for interests in finance equal to 0.01% or 0.0001 in decimal form. The committee commented that this was meant to curb the continued surge of inflation away from the single target band of 6-8% and persistent rise in inflation expectations which if left unchecked, poised to undermine macroeconomic stability and efforts towards a robust and sustained growth achieved so far.

?It is worth noting that average inflation rose to 13.5% in Q1 2024 from 12.9% in Q4 2023. In April, annual inflation increased to 13.8% from 13.7% in March. The inflation rate has surged to 15.2% in June, up from 14.7% in May.

To put this into perspective and to help understand what this means, I have discussed in this article the role of Central Banks and how they implement monetary policy through various tools and mechanisms to control the money supply, manage inflation to sustainable levels, and influence economic growth. The choice and intensity of these tools depend on the economic context and policy objectives of the Government.

A Central Bank (“CB”) is a public institution that is responsible for implementing monetary policy, managing the currency of a country, and controlling the money supply. A central bank plays a crucial role in a country's economy, primarily focusing on maintaining economic stability and financial system efficiency. The central bank of the Republic of Zambia, the BOZ is mandated to create and implement monetary policy that aims to maintain the economic stability of the country. The BOZ is tasked with maintaining a certain level of stability within the country's financial system. Specific tools are afforded to the BOZ that allow for changes to broad monetary policies intended to implement the government's planned fiscal policy. These include the management and oversight of the production and distribution of the country’s currency, the sharing of information and statistics with the public and other government agencies , and the promotion of economic and employment growth through the implementation of changes to the MPR and economic policies . The most influential economic tool the BOZ has under its control is the ability to increase or decrease the MPR. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing. This will be discussed further in this article as it’s the main focus of this publication. As we delve deep into this article , I start with discussing the main functions and roles of a central bank which are summarised below:

Monetary Policy ?

Central banks regulate the money supply and interest rates to control inflation, manage employment levels, and ensure economic stability. They use tools like open market operations, interest/discount rates, and reserve requirements by adjusting these upwards or downwards as the case maybe to achieve these goals. We will discuss these in more detail later in this article.

Reserves Management and Foreign Exchange

Central banks manage the country’s foreign exchange reserves and engage in foreign exchange operations to stabilize the national currency's value. They may intervene in the foreign exchange market to influence exchange rates.

Foreign Exchange Interventions

Central banks may intervene in foreign exchange markets ?i.e. buying and Selling Foreign Currency to influence the exchange rate, indirectly affecting the money supply and economic conditions.

Financial Stability

Central banks oversee and regulate financial institutions to ensure the stability and integrity of the financial system. They function as a lender of last resort to commercial and other banks during financial crises, providing liquidity to prevent bank failures and maintain public and financial market’s confidence both at local and international levels.

Currency Issuance

Central banks have the exclusive authority to issue and manage the nation's currency. They ensure there is enough currency in circulation to meet public demand, while also working to prevent counterfeiting.

Government Banking Services

Central banks serve as the banker and financial agent for the government. They provide banking services to Government, commercial banks and to act as a Settlement Agent. They manage the government's accounts, process transactions, and may also manage the issuance and redemption of government securities.

Research and Economic Analysis

Central banks conduct extensive research and analysis on economic and financial conditions to inform policy decisions. They publish reports and provide guidance to the government, financial institutions, and the public.

Consumer Protection and Regulation

Central banks often have a role in consumer protection, ensuring that financial products and services are fair and transparent. They ?license, regulate, and supervise banks and financial service institutions. They may regulate and oversee payment systems to ensure efficiency and security.

Through these functions and roles, central banks aim to create a stable economic environment that fosters growth for both private and public sector institutions, controls inflation, creates employment opportunities and maintains public trust in the financial system.

Central banks implement monetary policy through various tools and mechanisms to control the money supply, manage inflation, and influence economic growth. Below I delve deep into discussing exactly how the monetary policy is implemented by Governments across the globe through the central banks and the primary methods they use to achieve their objectives:

Open Market Operations (OMOs)

This relates to the buying and selling of Government Securities. The central bank buys government bonds, treasury bills to increase the money supply and reduce interest rates, stimulating economic activity. Conversely, selling government bonds decreases the money supply and raises interest rates, cooling down the economy..

Interest (Discount) Rates (MPR)

Central bank set the base interest rate known as the MPR in Zambia. For banks and depositories, it is the interest rate assessed on funds acquired from central banks. In other words, the MPR is the interest rate at which banks can borrow from the BOZ directly. The MPR can be interpreted as the cost of borrowing from the central bank. Financing received through the central bank’s lending is most commonly used to shore up short-term liquidity needs for the borrowing financial institution, as such, loans are extended only for an overnight term. The most influential economic tool that the central bank has under its control is the ability to increase or decrease the interest rates/MPR. Shifts in this crucial interest rate have a drastic effect on the building blocks of macroeconomics, such as consumer spending and borrowing. Interest rates are determined, in large part, by central banks who actively commit to maintaining a target interest rate. They do so by intervening directly in the open market through open market operations (OMO), buying or selling Treasury securities to influence short term rates. These rates, in turn, ripple out to inform many other rates on mortgages and commercial and retails loans, corporate bonds and bank deposits. Ultimately, the supply and demand for loans and credit in the market will dictate interest rates over the long run. Lowering the MPR makes borrowing cheaper, encouraging banks to lend more, thereby increasing the money supply. Raising the MPR has the opposite effect.

Effects of increasing Interest Rates

Central banks control short-term interest rates, which in turn impact all other interest rates as explained above in order to affect their reserves, which when the economy is growing at a rate that may lead to hyperinflation, the central may increase interest rates. When member banks cannot borrow from the central bank at an interest rate that is cost-effective, lending to the consuming public may be tightened until interest rates are reduced again. An increase in the interest rate has a direct impact on the interest rate charged to consumers for lending products, and consumer spending shrinks when this policy is implemented. When a central bank raises interest rates, its goal is to slow down the economy. Raising interest rates will increase the cost of borrowing because loans now come with higher interest rates. This makes the purchase of goods and services on credit more expensive. Consumers will decrease their spending, resulting in a slowdown of the economy.

Effects of decreasing Interest Rates

When the central bank make a change to the MPR, economic activity either increases or decreases depending on the intended outcome of the change. When the nation's economy is stagnant or slow, the central bank may enact its power to reduce the MPR in an effort to make borrowing more affordable for member banks. When banks can borrow funds from the central bank at a less expensive rate, they are able to pass the savings to banking customers through lower interest rates charged on personal, vehicle finance, or mortgage loans. This creates an economic environment that encourages consumer borrowing and ultimately leads to an increase in consumer spending while rates are low.

Although a reduction in the discount rate/MPR positively affects interest rates for consumers wishing to borrow from banks, consumers experience a reduction in interest rates on savings as well. This may discourage long-term savings in safe investment options such as money market savings accounts.

How Raising Interest Rates curb rising Inflation

When a central bank raises interest rates, its goal is to slow down the economy. If the economic growth rate is slowing, the Government might implement an expansionary monetary policy to try to boost the economy. If the growth rate is robust, they might use monetary policy to slow things down to try to ward off inflation. If Gross Domestic Production (“GDP) growth rates accelerate, it may be a signal that the economy is overheating and the central bank may seek to raise interest rates. Conversely, central banks see a shrinking (or negative) GDP growth rate (i.e., a recession) as a signal that rates should be lowered to stimulate growth. Rising interest rates make the cost of buying goods and services more expensive because the cost of borrowing money is more expensive due to higher interest rates on loans. When the cost of goods and services is more expensive, this discourages people from spending, reducing the demand for goods and services. When consumers decrease their spending, this results in a slowdown of the economy. According to the law of supply and demand, when demand falls, prices of goods and services fall as well. When prices fall, inflation comes down and eventually stops

Overnight Lending and Bank Reserves

Banks and other financial institutions are required by the central bank to have a minimum amount of reserves on hand. Lowering reserve requirements allows banks to lend more of their deposits, increasing the money supply. Raising reserve requirements restricts the amount of money banks can lend, decreasing the money supply. Each day, bank reserves are depleted or augmented as customers carry out day-to-day banking operations and make payments, withdrawals, and deposits. At the end of the business day, if more cash withdrawals had been made than deposits, the bank may have found itself with too little reserves, left, and would have been below regulatory requirements. It would then have had to borrow the additional funds via overnight lending as a short-term loan to meet the minimum amount of reserves required. Remember, the interest rate on the interbank overnight borrowing of reserves adjusts to balance the supply of and demand for reserves. For example, if the supply of reserves in the BOZ funds market is greater than the demand, then the rate falls, and if the supply of reserves is less than the demand, the rate rises. Furthermore, central banks can influence the amount of reserves banks hold by paying interest on excess reserves. Higher interest on reserves can encourage banks to hold onto their reserves rather than lending them out, thus tightening the money supply. Lower interest encourages banks to lend more.

Quantitative Easing (QE) and Quantitative Tightening (QT)

When traditional tools are insufficient, central banks may buy a broader range of financial assets (such as longer-term government bonds or mortgage-backed securities) to increase the money supply and lower long-term interest rates which is referred to as Quantitative Easing. Conversely, selling these assets can help reduce the money supply and increase long-term interest rates. This is referred to as Quantitative Tightening.

Conclusion

The BOZ, like all central banks, uses interest rates to manage the macroeconomy. Raising rates makes borrowing more expensive and slows down economic growth while cutting rates encourages borrowing and investment on cheaper credit. All this ripples out from the overnight lending rate that banks must utilize in order to maintain their required reserves of cash which is also set by the BOZ. When consumers decrease their spending, this results in a slowdown of the economy. When prices fall, inflation comes down and eventually stops. Higher interest on reserves can encourage banks to hold onto their reserves rather than lending them out, thus tightening the money supply. Lower interest encourages banks to lend more.

By using these various tools and mechanisms, central banks aim to manage money supply, control inflation, manage employment levels, stabilize the financial system, and influence & support sustainable economic growth. The choice and intensity of these tools depend on the economic context and policy objectives of the Government.