Examining the Role of Central Banks

Spotlight: The Role of Central Banks

You may have seen in the news that on 9^th May the “Bank of England agreed to maintain the policy rate at 5.25%”. But what does this really mean and what are the expected impacts of this decision on the UK economy?
 
The Bank of England is the UK Central bank. Central banks are national or regional financial institutions that control and manage the money and financial system of a country or group of countries. They play an important role in the economy by helping manage interest rates, stabilise the financial system and control how much money there is circulating in an economy (the money supply). To do this, some of the key tools in their toolkit are:

1. Setting the policy rate (the 5.25% rate mentioned above), which influences the borrowing and lending rates in the wider economy:

   • Lowering the policy rate (and therefore broader interest rates) makes borrowing cheaper, stimulating economic growth through higher spending and investment which can lead to increasing inflation.

   • Raising the policy rate (and therefore broader interest rates) makes borrowing more expensive, encouraging saving and lower spending, which can help control inflation.

2. Buying or selling government securities (e.g. UK government bonds) in the open market to regulate the amount of money in the banking system:

   • When a central bank buys securities, it adds money into the banking system, increasing money supply and lowering interest rates.

   • When a central bank sells securities, this takes money out of the banking system, decreasing money supply and increasing interest rates.

3. Issuing currency – central banks have the exclusive authority to issue national currency (banknotes and coins) to ensure there is an adequate supply of currency to meet the needs of the population.

4. Regulating and supervising financial institutions to ensure the orderly function of the financial system.

5. Providing emergency funding to financial institutions facing cash shortages to prevent systemic crises.

 
In the UK, the Bank of England increased the policy rate 14 consecutive times from December 2021 to August 2023 in order to tackle high inflation. Interest rates have now been left unchanged at 5.25% from August 2023 up to and including in their latest meeting on 9^th May. The UK 12-month CPI measure of inflation (which measures the price you pay at the supermarket check-out, the petrol pump, and many other places) released last Wednesday showed headline inflation at 2.3% in April - this is getting much closer to the Bank of England’s long-term 2% inflation target. As a result, markets are now expecting the Bank of England policy rate to fall in the latter half of this year.
 
It is important for central banks to strike a balance between reducing interest rates too quickly, resulting in another uplift in inflation, and keeping interest rates higher than they need to be for too long, which may result in difficult financial conditions or tip an economy into a recession (two quarters of consecutive negative economic growth). Central banks tend to use several data points to decide what to do to strike this balance such as GDP growth, unemployment data, consumer spending data, and the different measures of inflation.
 
In the US, the central bank is called the “Federal Reserve” (or “the Fed” for short). The story in the US is similar to the UK, however inflation has remained at a higher level in comparison to the UK as prices have remained elevated for longer – remaining around 3.4% in April (US 12-month CPI), above the Fed’s 2% inflation target. This means that rate cuts by the Fed could come later than the UK given the higher inflation and evidence of the US’s robust economy despite higher interest rates.  
 
The chart below shows the change in both the Bank of England policy rate and the Federal Funds Rate over the past 10 years. As you can see, these rates were cut following the COVID-19 pandemic in order to stimulate the economies, but following persistently high levels of inflation, the respective rates increased dramatically. Whilst the policy rates in the US and UK have moved broadly in tandem in the past years, there is a possibility we now see divergences as the Bank of England is likely to cut policy rates more quickly than the US.
 

The Noise​

• Eurozone inflation rose by 2.6% year on year in May, with the data coming in slightly hotter than consensus expectations of 2.5%. The larger-than-expected increase in inflation is unlikely to stop the European Central Bank from lowering borrowing costs from a record high next week but may solidify the argument for a pause in July and a slower pace of interest rate reductions in the coming months. Eurozone inflation is inching away from the ECB’s 2% target after increases of 2.4% in April and March, though was likely to do so given bigger-than-expected increases in wages in the first quarter of 2024. Diverging rate expectations, with the Bank of England keeping rates on hold for now while the ECB will begin cutting has sent the Euro to its weakest in a year versus the pound this week. Your usual weekly review writer cannot wait to reap the benefits on his holiday to Greece next week.

• Prices in British shops grew at the slowest pace in two and a half years this month, up 0.6% in May per the British Retail Consortium. Down from 0.8% in April, the consortium indicated that the rate of inflation in the sector was back to normal following its almost three-year surge. Food inflation also slowed for a 13th straight month to 3.2% from 3.4%. After a number of months of falling input prices, food inflation is now stabilising, as retailers continue to pass on price cuts to shoppers. Despite easing inflationary pressure and improved shopper sentiment, poor weather has dampened retail sales over the last couple months. This will help lower prices further as retailers look to increase and drive demand.

• Telecommunications companies across the world are looking to tap into a rich new source of revenue: their old copper wiring. In the global shift to fibre-optic cable, telecom companies could recover as much as 800,000 metric tons of copper over the next decade, worth more than $7 billion at today’s prices. This is being viewed as an enormous commercial opportunity, as demand for copper is expected to grow more than 50% in the next 15 years. It is a critical component in electric-vehicle batteries, wind turbines and other clean-energy infrastructure, and with mining becoming more difficult and expensive, this could be a small way to satisfy growing demand. With copper prices now 50% higher than pre-Pandemic levels, telecom firms are scaling up their copper recycling efforts. 

The Numbers

The Nuance

The Federal Reserve published its ‘summary of commentary on current economic conditions by Federal Reserve District’ this week. The report is more commonly known as the Beige Book and is published eight times per year. Each Federal Reserve Bank, of which there are 12, gathers anecdotal information on current economic conditions in its district. It does so through reports from bank and branch directors, as well as interviews with key business contacts, economists, and market expert. So, what did the Beige Book tell us about the state of the US economy?

Everything, as they put it, was very modest. The US economy expanded at a “slight or modest” pace across most regions from the start of April, with consumers pushing back against higher prices per regional business contacts. This was also reflected in retail spending, which was “flat-to-up slightly”, reflecting lower discretionary spending and heightened price sensitivity among consumers. Overall outlooks grew somewhat more pessimistic amid reports of rising uncertainty.

Employment also rose at a slight pace, with eight of the 12 districts reporting “negligible to modest” gains. Prices increased at a “modest pace” over the period, as business contacts again cited consumers pushing back against further price increases.

The latest Beige Book failed to give Jerome Powell and his fellow Federal Reserve officials any reasons to change their tune. They will continue to preach patience and wait for more evidence that inflation continues to cool before deciding to cut rates.

 

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