With the rise of inflation over the past few years, central banks worldwide have come into the spotlight. Central banks play a vital role in the economic health of a nation and through their actions they can impact financial markets and ultimately the performance of your investment portfolios.
What is a Central Bank
A central bank (CB) is a public institution that is concerned with promoting economic stability and growth. Low inflation plays an integral role in ensuring economic stability and central banks are charged with the task of controlling it. Central banks are able to use a set of different tactics that are part of their Monetary Policy toolkit to achieve these objectives:
Apart from being responsible for an economy’s Monetary Policy, a central bank can be tasked with several other roles.
Monetary Policy Impact on Financial Markets
As mentioned, higher interest rates can cause an economic slowdown. This creates concerns in regards to companies’ potential future profits which causes a drop in stock prices. Simultaneously, savings and newly issued bonds now offer a higher return on your investments. This makes lower-interest-paying bonds that were issued in prior years and which might be part of your portfolio less attractive resulting to a drop in their prices.
Alternatively, lower interest rates can have the opposite effect. In addition, if the central bank is buying bonds from commercial banks, it increases demand for bonds which pushes up bond prices.
What is happening now
In 2022, central banks globally started to drastically increase interest rates to fight-off stubbornly high inflation which has since dropped to levels much closer to central banks’ targets. In cases such as Eurozone and Sweden, higher interest rates have indeed resulted in a slowdown in economic activity which has allowed the central banks of those economies to start lowering rates. In the United States on the other hand, the economy has shown little sign of slowing down. This has made the Federal Reserve more hesitant to cut rates because if they do so too soon, it could rekindle higher inflation. As the US is house to the largest stock and bond market in the world, it makes sense that investors are eager to see when will the Federal Reserve cut rates.