What is a central bank?

A wintry sky hangs over the Federal Reserve Building in Washington January 22, 2008.  The U.S. Federal Reserve on Tuesday slashed U.S. interest rates by a hefty three-quarters of a percentage point, the biggest rate cut in more than 23 years, in an emergency bid to lend support to a U.S. economy some fear is on the verge of recession.  REUTERS/Kevin Lamarque  (UNITED STATES) - GM1DXCEYVGAA

Guiding growth: The US Federal Reserve Building in Washington Image: REUTERS/Kevin Lamarque

Sophie Hardach
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Jerome Powell will take over from Janet Yellen as Chair of the U.S. Federal Reserve, and is expected to continue her policy of gradually unwinding the economic stimulus. But what does that actually mean? What is the role of central bankers, and why can they move entire financial markets with a single word? Here is a quick guide to how central banks actually work, why they matter so much in the modern economy, and how they might evolve in the future.

What do central banks actually do?

Central banks like the Federal Reserve set official interest rates to support steady economic growth. This is one of their most important tasks, since it determines the cost of borrowing and lending money. When interest rates go up, so does your mortgage and any other debt, for example business loans. As a result, fewer people buy houses, or borrow money to invest in their businesses, and the economy slows. To stimulate the economy, central banks can lower the official interest rate, which makes it cheaper to borrow money. Borrowing goes up, and the economy gathers pace - at least in theory.

Why does this matter?

Economic growth is directly tied to employment. Broadly speaking, faster growth means more jobs. But if the economy grows too fast, it can overheat. People take on too much debt, and may not be able to repay it. The central bank supplies too much money, and prices rise too fast. In the worst case, an oversupply of money can lead to out-of-control inflation. Hyperinflation ravaged the German economy in the early 1920s, for example, after the government tried to print its way out of its First World War debt. At its most extreme, hyperinflation was so severe that the price of two cups of coffee rose while a customer was drinking them. Many historians argue that such economic turmoil paved the way for the rise of fascism.

Piles of new banknotes during Germany's hyperinflation era Image: Bundesarchiv

How do central bankers hint at a future rate rise?

Investors generally want central bankers to be stable and predictable. They need to know what's ahead, so they can plan their investments accordingly. It's difficult to build a business or manage a portfolio if you are constantly tripped up by surprise interest rate moves that jolt the entire economy. This is why many central bankers try to signal an increase or decrease in rates well in advance (though they may sometimes resort to the power of a sudden move). Successfully decoding their subtle warnings can be an art in itself.

For example, when Jean-Claude Trichet was president of the European Central Bank from 2003 to 2011, one of his recurring phrases was that the bank needed to remain 'vigilant' about inflation. Whenever he slightly altered his message and said that 'strong vigilance' was warranted, investors knew from experience that this signalled a rate rise, often the very next month. As a result, the euro usually fell right after such an announcement - all because of the addition of a single word. Trichet's successor, Mario Draghi, has also used the word 'vigilant' to signal monetary policy action (in his case, to stimulate rather than restrain the economy), and markets have moved in response.

What other responsibilities does a central bank have?

Central banks like the Federal Reserve increase and decrease the money supply by buying and selling bonds. The more money circulates, the easier it is to lend and borrow. Central banks also manage foreign exchange reserves and act as a lender of last resort. They decide how much banks can lend and how much money they must retain. Lowering the reserve requirement - the proportion of capital that banks must hold - can also stimulate the economy since it frees up money for lending.

Since the wake of the 2008 financial crisis, central banks have resorted to a range of unconventional measures to revive economic growth. They have injected money into commercial banks by buying bonds from them, in the hope that the banks will then lend this money to investors. Europe's and Japan's central banks have cut their key interest rates to below zero, effectively penalising banks for saving rather than issuing loans.

Shoppers walk under umbrellas as Typhoon Lan approaches Japan's mainland, in Osaka, western Japan, October 22, 2017. REUTERS/Thomas White - RC1BF761A190
Super-low interest rates in Japan and Europe aimed to beat economic gloom Image: REUTERS/Thomas White

Powell is taking over the Fed at a time when central bankers are under pressure to eventually return to more normal economic conditions, since super-low interest rates hurt an economy in the long run. They distort saving and lending behaviour, and leave the central bank with no room for manoeuvre when a big crisis hits.

Have central banks always been this important?

Arguably, central banks play a particularly important role in the modern, globalised economy, where the effect of a single rate rise in a major economy ripples around the world. On the other hand, central banks have influenced global politics and economics ever since they came into being. The world's oldest central bank, Sweden's Riksbank, was founded in 1668, and soon after financed a war against Denmark.

So central banks are all-powerful?

Yes and no. Their decisions shape the economy, but other factors also matter. A skilled workforce, technological innovation, good infrastructure and access to equal opportunities are crucial in creating strong, healthy growth, to name just a few obvious elements.

How was Powell appointed, and what are his main challenges in his new job?

In the U.S., the president appoints the chair of the Fed. President Obama appointed Yellen, and President Trump appointed Powell, a lawyer by training who had been a Fed governor since 2011. Under Yellen, the Fed raised its benchmark interest rate four times as it gradually moved towards unwinding its economic stimulus. Powell is expected to broadly continue this policy of slowly returning rates to more normal levels.

Interest rates are expected to slowly return to more normal levels Image: Thomson Reuters
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