Central Bank Policy

Central banks (CB) control money supply and interest rates. In extreme conditions they use the following tools to keep economies on track.

Quantitative Easing (QE)

QE = central banks injecting money into the economy by buying government bonds.

• CB buys bonds which increases bond demand

• Bond prices increase causing yields to decrease

• Banks sell these bonds receiving cash so they can now lend more freely

• Lower yields = lower interest rates

• Borrowing is now cheaper promoting economic activity

QE is typically used when interest rates can’t be cut any further.

Risks:

• Inflation: More cash chasing the same goods = rising prices

• Inequality: Asset owners (stocks, real estate) benefit much more creating further wealth disparity

• Asset bubbles: Investors chase risky assets e.g. crypto, as bonds pay less. If rates rise these assets can plummet fast!

Quantitative Tightening (QT)

QT = reversing QE. Central banks either sell bonds or let existing ones mature.

1. Active QT (Selling bonds)

• CB sells bonds increasing bond supply in the market

• Bond prices fall causing yields to rise

• Higher yields cause higher interest rates meaning borrowing is more expensive

2. Passive QT (Maturing bonds)

• CBs let bonds expire, governments then repay face value

• CB essentially sits on that cash (doesn’t reinvest)

• Liquidity drains from the market

QT is used when inflation is running hot, or economies are overheating.

Forward Guidance

This is where central banks signal their future intentions

Why it matters:

• Reduces market uncertainty

• Helps businesses/consumers plan around expected conditions

I hope this article on government policy was helpful. For the rest of my articles please click here.