How Central Banks work, and why they don’t

The Central Bank, is the entity responsible for the issue of a certain currency. The most famous central banks are The Federal Reserve of the U.S. and the European Central Bank in Europe.

Most central banks have a dual mandate, compromising to keep inflation at a stable 2% and also promising to step into action if employment falls too much. The main mechanism Central Banks use nowadays is interest-rate manipulation. They adjust base money, to increase or decrease the liquidity in the market, therefore pushing short-term interest rates up or down. This can be done via bond purchases, or also with repos, loans of short maturity.
In reality, the central Bank cannot just “set” the interest rate. Rather, the bank has a target, in the U.S. it’s the fed funds target rate and in the ECB it’s the main refinancing rates. Adjusting these, which is the interest rate the Central Bank charges on its loans, the interbank rate also changes. The interbank rate is called the marginal lending facility in Europe and the Fed funds effective rate. This is the rate at which regular institutions lend money to each other, on aggregate. This also happens through the central bank since it acts as a clearinghouse for all interbank payments.
So this is how it works more or less today. Basically, they manipulate interest rates.
Of course this is very different from the original intention of Central Banks.
Originally these institutions were supposed to act as a “lender of last resort” in the case of a liquidity crisis. Note that these liquidity crisis, due to technological innovation would not even occur today.
But the bank was not supposed to be active. It was only supposed to participate in the market briefly, and in a small, self-reversing manner, giving out loans only at a “penalty” rate, so this function was only used during liquidity crisis, when interbank interest rates went waaay up.
In addition to this, Central Banks, used to manage the currency following the gold standard “rules”.
The idea of interest rate manipulation didn’t come into existence until just recently.

An that is the main reason why Central Bankers today don’t know what they are doing. It is as if they were trying to drive a car, but the break and steering wheel are disconnected. Manipulating interest rates is not a good way of managing currencies. So, for example, it isn’t necessarily true that if you wanted to avoid inflation all you had to do is raise interest rates. This is not an effective mechanism for controlling the value of the currency.
And, most importantly, like I’ve said before, there is no real indication anywhere, that manipulating interest rates can have a real effect on the economy. Many say it’s like pushing on a string.

So the main difference here is that while “old-school” central banks favoured the classical view of money, that it should be a stable measure of value, modern day central banks favour the mercantilist view, that currencies should be used to achieve short-term goals, to fund government deficits or trying to reduce unemployment.


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