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Central banks conduct monetary policy, but their reach exceeds price control, and investors pay great attention to their decisions. In this column, we describe the reasons behind their interest.

 

The restrictive measures that started to take place in 2020 had a great impact on economic growth. Since then, both citizens and governments have been in expectation of a recovery that would put the countries back on a growth path. Central banks have been using all the tools available to fulfill this purpose, but this year, along with recovery came a higher demand for goods and services, causing an increment in both current prices and price expectations.

As a consequence, central banks are reevaluating their strategies. As an example, during the Jackson Hole symposium, the US Federal Reserve Chairman manifested that the Fed plans to reduce its monthly purchase of Treasury bonds this year, although a rate increase is not under consideration yet. This purchase reduction is commonly known as tapering.  Within our region, the Central Bank of Chile has increased its interest rate by 75 basis points to 1.5%, its highest in two decades, thus joining an increasingly large group of central banks in Latin America.

Broadly speaking, the objective of central banks is to ensure price level stability. But to understand how their stances vary, one must begin by understanding the instruments that they apply. It should be noted, though, that inflation is not the only problem. Low price dynamics or even deflation may be an obstacle, too, since their existence evidence some kind of issue in terms of supply and demand for goods and services that will eventually lead to the deterioration of the economy.

 

Hawkish vs Dovish: interest rates

The repurchase or repo rate is among the central banks’ better-known monetary policy tools. Repo rate fluctuation indicates whether a central bank is aiming at an expansionary or contractionary monetary policy, by increasing or reducing the money supply.

An increment in interest rates is a contractionary policy: at higher rates, repurchase agreements between commercial banks and the Central Bank become more expensive. Commercial banks are expected to replicate fluctuations in the repo rate, raising their loan interest rates. When this occurs, households tend to avoid getting into debt, which contracts consumption expenditure and consequently diminishes upward pressure on price. When interest rates are lowered, the opposite is expected to happen: consumption expenditure will eventually grow, leading to economic growth.

Chart. Own elaboration. Source: Investing.com

 

Regarding interest rate decisions, the strategies adopted by central banks are described using characteristic terms. Hawkish refers to a central bank concerned about current and future inflationary pressure, with a tendency toward increasing interest rates; and its opposite is known as a Dovish stance. The chart displays how the central banks of many relevant economies in Latin America have adopted a Hawkish stance to face the increase in both inflation and inflation expectations.

But the interest rate policies of central banks have implications that go beyond consumption expenditure and commercial banks loans. Their policies have quite an impact on the bond market, particularly on short-term bonds, since fluctuations in interest rates can make them more or less attractive to investors.

 

Quantitative Easing vs Money Printing

Another instrument that central banks possess to adjust the amount of circulated money is buying and selling government securities. To increase the money supply, central banks buy securities and keep them for long periods. To reduce it, they will do the contrary. It was during the 2008 crisis that this approach became especially relevant. The Fed took it to a new level and named it Quantitative Easing (QE). Back then, it bought not only short-term treasury bonds, as was usual, but it also purchased long-term bonds and mortgaged-back securities.

At the start of the pandemic, these QE strategies became quite popular among central banks that sought to boost economic growth while reducing their interest rates. A strategy to reverse this situation consists of beginning with tapering or purchase reduction and eventually selling the securities in an orderly manner.

But, at this point, it should be noticed that some have confused this instrument with a different, quite controversial one: money printing. Since central banks have the authority to print money, an option to increase the money supply is by doing so and giving it to the government, which would then use that money to pay its bills. But this process has fundamental implications. The most noticeable one is an out-of-control inflation increase: the supplied money is not backed by any goods or services, leading to an artificial increase in demand and consequently to higher prices. The confusion between these tools lies in the origin of the resources utilized to purchase securities. If the central bank is printing, that “new” money would be injected into the economy; if instead, it utilizes its reserves, then it is using money that already existed.

 

The reserve ratio

The last tool to consider may be the one with the most direct incidence: the determination of the reserve ratio. The reserve ratio establishes the amount of money that banks must keep as a reserve to cover their customers’ withdrawals. Banks allocate the exceeding amount to lending and investment. If a central bank seeks to inject money into the economy, it may reduce this ratio, leading to banks giving more loans. The risk with this type of strategy is that it may affect the soundness of commercial banks and create a trust crisis among customers.

As a closure, it should be noted that even though the direct impact of the instruments available to central banks and monetary policies may be limited, investors are affected by the signals sent. That is why everyone pays close attention when a central bank has something to say.

 

 

This report was made by Gandini Análisis for SupraBrokers only as content. It shall in no case be considered as an investment recommendation.

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