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What is a Central Bank?

A decade on from the financial crisis and all eyes are on the Bank of England as it looks to normalise monetary policy. But what do Central Banks really do?

Following the global financial crisis, Central Banks tried to boost the economy by slashing interest rates and launching quantitative easing (QE) programmes – where new money is created to buy investments like government bonds.

Nearly a decade later and monetary policy hasn’t really changed. Central Banks want to return to normal monetary policy, but tightening the strings could have a knock-on effect on consumer finances and the financial markets. Some, like the Federal Reserve, are further along the path to normalisation than others, however.

What does a Central Bank do?

The role of Central Banks varies around the world. In the UK, the Bank of England controls monetary policy, regulates the banking industry and provides government services. Monetary policy essentially means controlling the supply of money in the economy.

To avoid another household credit crisis, the Bank of England recently tightened industry regulation around household debt.

The US Federal Reserve, which was set up in 1913, and the European Central Bank perform similar functions to create a safer, more flexible and more stable financial system.

How do Central Banks control inflation?

Inflation is an important concept that’s often ignored by savers and investors. Inflation measures the rate of price growth for general goods and services by monitoring the value of an extensive shopping basket of items.

Inflation gauges how these prices fluctuate over time. In a healthy, growing economy, consumers and businesses spend more, and this increased demand pushes up prices. As demand weakens, so does prices growth and the economy enters a period of disinflation, before deflation – falling prices – takes hold.

Why is inflation important to savers and investors? Well, it reduces the purchasing power of cash over time, so any money sat in a savings account with negligible returns will be losing real value.

How does monetary policy work?

Central Banks try to keep inflation close to a target set by the government – currently at 2% in the UK – by adjusting monetary policy – namely interest rates and QE.

As higher inflation can be a symptom of an overheated economy, Central Banks might tighten monetary policy to ease the pace of economic growth.

If price growth in subdued, the Bank of England might loosen monetary policy to stimulate demand – as they did after the financial crisis.

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The Bank rate

By changing the Bank rate, Central Banks can influence the rates offered by high street banks and building societies.

Cutting the Bank rate will feed through into the returns offered on savings accounts like cash ISAs, which is bad news for savers. The returns on cash ISAs have collapsed from around 6% in 2007 to just over 1% today.

Borrowing, however, becomes much more attractive in a low interest rate environment. With cheap money readily available, spending is encouraged. An uptick in spending increases demand for goods and services, which drives inflation higher – as explained before.  

Interest rate changes also impact the financial markets, boosting the value of homes and equities, for example.

What is quantitative easing?

Central Banks have another tool in their monetary policy arsenal; quantitative easing. If the bank rate is low but inflation is on course to fall below the government’s target, Central Banks can inject money straight into the economy to encourage spending.

The Bank of England, for example, will create new money electronically to buy investments like government bonds. By lowering the cost of borrowing and increasing asset prices, spending should increase.

This is a new form of monetary policy used for the first time after the financial crisis – the Bank of England introduced QE in March 2009 – and there are still concerns over how economies might react to the taps being turned off. A binge on cheap debt could also spell trouble if interest rates are hiked.  

Central Bank independence is important

Given that the Bank of England’s decisions are felt across the UK and around the world, it’s important the Central Bank is operationally independent from the government.

Former Chancellor of the Exchequer Gordon Brown gave the Bank of England responsibility for setting monetary policy to achieve the government’s inflation target in 1997. Before then, monetary policy used to be controlled by the government.

The bold move was designed to modernise the traditional system, but it doesn’t mean the Bank of England is always right. Mark Carney came under fire for saying the economy would immediately struggle following Brexit, for example. Fed Chair Janet Yellen has even admitted in the past that inflation can be mysterious.

With the power to influence whether we save or spend, Central Banks hold a crucial role in the economy. But it’s important to know that even in a low interest rate environment, there are still opportunities to make your money go further, and prepare for the future.

Investing can help take control and look to protect your money from the impact of inflation, and get you one step closer to your financial goals.

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