One of the areas of topics that deeply interest me personally is macro-economics in practice. If the word ‘Macro-economics’ makes you yawn, I don’t blame you! When I learnt about it in textbooks back in school, I used to think this was pretty boring and would never add value to my life. However, over the years, as I have started to see it in more practical applications and see how it impacts my life, I have gotten more interested. The field is a large one and certainly I cannot claim to be an expert. This article kicks off a new section in my blog where I will aim to educate you on how to think about this in a way that pertains to your personal finances. As always, I will aim to keep this simple. Money can be simple, after all. 🙂
Its Sep 2008. There is an emergency meeting being held at the US Federal Reserve. There is panic in the markets. Everyone is looking to them to see what they are going to do. After all, the Fed is the banker of last resort and helps us anytime, doesn’t it? The men in suits are screaming at each other and loudly debating what they need to do.
If this feels like a scene out of a Hollywood movie, then you may be both right and wrong. The scene was real and we all have seen a number of articles and movies depicting what some of the politicians did that day. One man – Ben Bernanke was in the middle of all this. He was the leader of the US Federal Reserve, the central bank.
So one of the first areas of contemporary interest in economics is what the central bank does and why it impacts our lives. This is an area in macroeconomics called monetary policy. I am going to do my best to steer away from economic jargon. But it is very important for us to understand the impact of a central bank in our day to day lives and to our personal finances. I want to explain in as simple a way as possible.
Who or what is a central bank?
Let’s start with the basics. A Central bank is a financial institution that does two things fundamentally – one, it sets the policy and regulations for the banking industry in a country and two – it has the power to impact the amount of money supply in an economy through the implementation of its policies.
Examples of central banks are the Federal Reserve in the US (also known as the Fed), the European Central Bank (ECB) for the Euro Zone, Reserve Bank of India (RBI), the People’s Bank of China (PBOC).
So what is a Central Bank’s goal?
Fundamentally, central banks are focused on managing two key measures – inflation rate and unemployment rate. Different countries have different target levels. Why these 2 measures? Because they fundamentally drive the economic prosperity of a country and the government has given the central bank the mandate to manage these 2 measures. We will talk about how in a bit.
- Inflation rate – Central Banks live and breathe based on the rate of inflation in the economy. In most recent years, the US Fed has targeted around 2% inflation as a good rate of inflation. Why 2%? Its a bit of a rule of thumb really – it’s a bit of a goldilocks % that’s not too high or too low. Anything significantly higher or lower causes the central bank to take action to bring the economy back to this 2% level. Pretty much any policy or action the central bank adopts is to manage this rate of inflation in the economy.
- Unemployment rate – The rate of unemployment tells us whether the economy is in a good or bad shape. Unemployment and inflation typically have an inverse relationship. When unemployment is low, inflation tends to be higher and vice versa. The theory is that if unemployment is really low then people are doing well and can demand more goods causing prices to rise (i.e. inflation). When unemployment is high, people dont have the ability to buy a lot causing demand to reduce and thereby reducing prices (lower inflation). Now, economists have lately been debating how well correlated the two are in modern times.
So how on earth does the central bank influence the inflation rate and the unemployment rate? They don’t directly control which companies can hire or fire or for that matter how much companies can charge for their products. The Central bank does this in an indirect way by controlling 2 things – interest rates and money supply in the economy.
Central Bank role in Interest rates
This can be an entire article by itself but I will keep this short and simple. The Central Bank basically has the power to determine the interest rates in the banking sector in a country. Now, there is more technicality to this so I am going to oversimplify here. The central bank looks at where the economy is in terms of inflation and unemployment and decides whether to increase or reduce interest rates or keep them at status quo.
In 2020, when the pandemic hit, demand dramatically dropped due to the lockdowns, unemployment suddenly shot up. Inflation had dropped to almost zero because demand had dramatically dropped. The US federal reserve decided to immediately drop the interest rates down to zero. The reason they did what they did was because they wanted to get commercial banks to lend money to businesses and individuals for extremely low interest rates thereby making money readily available in the economy. This helped stimulate demand (this was not the only reason why this happened – I will explain that later in this article). At the time of writing this article in Jul 2022, the opposite is happening. Inflation is at a 40 year high north of 9% in the US. The US Fed has been raising interest rates rapidly over the last many months. This is because the economy has overheated due to demand increasing rapidly. The US Fed therefore wants to reduce demand and by raising interest rates, they now cause banks to raise interest rates – this makes it more expensive for people to borrow money thereby reducing the money supply in the economy. This in turn reduces demand, bringing down prices and inflation.
The relationship between interest rates and consumer demand is an important one to understand and that’s what I tried explaining in the previous paragraph.
Central bank role in money supply – quantitative easing
Now, there is another way by which the central bank can increase money supply beyond simply changing with interest rates. This is a more non-conventional and more recent approach. In modern times, what central banks were getting faced with was already low interest rates but still the economy was not doing well. Well, if interest rates are already low or zero, what else can they do? Enter quantitative easing.
Quantitative easing simply means that the central bank is going directly into the market buying long term government and corporate bonds. By buying these bonds, they end up reducing the amount of bonds available in the market. This causes bond prices to go up. So this next part might be confusing – when bond prices go up, the interest rates they offer actually go down (the relationship between bond prices and interest rates is something I will explain in a different article. For now, just understand bond prices and their yields / interest rates have an inverse relationship). These lower interest rates have the same effect to stimulate economies as lowering interest rates (there is a nuance to this that direct interest rate changes impact the short term and QE impacts long term interest rates but I am not going to drive you crazy here). The opposite effect is also true here – when the central bank decides to reduce quantitative easing, it causes long term interest rates to go up.
Hopefully the above 2 sections help you understand that the central bank has a powerful role to play in adjusting interest rates and money supply in the economy. When this happens, they make a wholesale impact on the health of the economy by impacting the inflation and unemployment rate.
Other ways of increasing money supply in the economy
There are a couple of other ways Central Banks increase money supply. One is a more traditional and boring way and the other is a more modern and radical way.
- Reserve requirements for banks – the more traditional approach and part of the mandate of most central governments is to determine how much cash reserves banks in the economy should maintain. Central banks can increase or decrease this reserve requirement. Increasing it reduces the amount of money banks have to lend in the economy and reducing it does the opposite.
- Helicopter money – this is a more recent and controversial role. This is more directly influenced by the politicians and government and the central bank is typically just executing this. What this means is that the government prints more money and simply gives it out to the people directly without any expectation of repayment. This is what the US government did during the great recession in 2008 and most recently in 2020. There are many pros and cons to this. But this can be enacted by directly giving people stimulus checks or some big tax breaks. It is believed that this has played an outsize role in leading to the current inflation rates in 2022 but this is of course being debated.
What does all this mean for me?
So while this is all interesting, how does this impact my day to day life? Our day to day lives are impacted in different ways:
- Interest rates for borrowing – If we wish to borrow money for anything (car loans, mortgages, credit card loans etc), the central bank’s actions are going to determine how expensive or cheap these loans are.
- Interest rates for saving – on the other hand, if you are trying to save money in a bank or other instruments, the interest rates will determine how much of a return you are going to get.
- Inflation – if the central bank policies are going to cause inflation to be high or low, it directly affects your pocket book on your day to day purchases.
- Asset prices – if you are trying to buy assets (real estate, stocks), you will notice this impacts the prices of these assets too. In an inflationary period, these will tend to be high and the opposite in a period when inflation is low.
Concluding thoughts
There is a lot of complexity and nuances to the above topic and I have done my best to keep it simple. My goal is to get you to understand the core concepts. There is not much to be gained for you to understand some of the technical details unless you are really interested in doing so.
So one obvious question is – I don’t control any of this so why even bother? You are absolutely right that you don’t control the central bank’s actions. But you do control where you invest your money, how you decide to save etc. That knowledge of understanding the central bank’s actions on your personal finances can be important as you make decisions on your investments and savings. It will also help you appreciate the different perspectives from economists on where the economy is headed.
Thank you for reading and I wish you success in your personal finance journey!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
