Monetary policy is the way that a central bank manages an economy to promote stable growth. It is a tool used to control the supply of money in the economy.
Over time, an economy can either overheat or contract too much. The central bank will subsequently adjust its monetary policy tools to bring the economy back to what it considers a stable position.
Here are the main tools of monetary policy:
- Interest rates – The central bank will change the level of interest it charges when it lends to domestic banks. The higher the interest rate, the higher the cost of debt. Banks pass on this rate rise to their customers in the form of higher rates on loans and mortgages.
- Open Market Operations – Central banks directly buy or sell bonds (usually government debt) from/to investors and banks. This increases the liquidity of funds on the balance sheets of institutions and increases the availability of money in the economy.
- Reserve Requirements – Central banks can change the required level of reserves that financial institutions need to hold to meet their liabilities. Lower reserve requirements increase the availability of funds to lend or invest.
Maintaining economic stability
Central banks use monetary policy to stabilise their economy. Here is how we can expect them to react to various economic conditions:
- Overheating economy (inflation is too high) – the central bank will use contractionary monetary policy. This will involve tightening monetary policy to choke economic activity. It can raise interest rates, sell bonds and increase reserve requirements.
- Contacting economy (too low or negative inflation, economic slowdown or negative growth, high unemployment is too high) – The central bank will look to use expansionary monetary policy to stimulate economic activity. It can lower interest rates, buy bonds and reduce reserve requirements.
Until the Global Financial Crisis of 2008/2009, central banks would traditionally focus on interest rates as the primary tool of monetary policy. However, despite cutting interest rates to zero, central banks felt the need to go further. Some banks took interest rates into negative territory. Some also started buying bonds. This operation was known as Quantitative Easing or ‘QE’.
Further economic shocks in the years since then have seen additional rounds of QE as a monetary policy response. Central bank enormously expanded their balance sheets.
However, in the wake of the COVID-19 pandemic, the huge inflation that QE helped to produce resulted in a reversal of the policy, towards Quantitative Tightening or ‘QT’.
QT involves the selling of bonds that are held by central banks. This reduces the assets on the balance sheet.
For example, the Federal Reserve started to engage in QT in 2022. The size of total assets on the Federal Reserve’s balance sheet peaked at just over 8.9 trillion USD.
Source: The Federal Reserve
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