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The recent crises linked to the pandemic and the invasion of Ukraine, and their consequences for the global economy, have brought central banks and their monetary policy back to the forefront of the economic scene. Although their main objectives concern the real economy, their actions also have consequences for the financial markets.
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The objectives of monetary policy pursued by central banks
Central banks are public economic institutions responsible for a country’s currency, or are part of an organization comprising several countries. While their main objective is to ensure price stability in an economy[1], particularly in advanced economies, some are assigned additional responsibilities, such as aiming for full employment or supporting the stability of the financial system. They are therefore responsible for steering monetary policy.
These responsibilities are conferred on them by mandates set by the states to which they report. Central bank governors are generally appointed by a government, with their candidacies subject to approval by Parliament, to which they are accountable and to which they must report regularly. Nevertheless, most central banks are politically and economically independent from their countries’ governments. This allows them to remain independent of short-term political considerations, which could undermine their medium- or long-term objectives and call into question the credibility of their interventions.
In order to conduct their monetary policy, central banks mainly act on the amount of money in circulation in the economy. By restricting this amount, they curb economic activity with the aim of limiting demand in order to reduce upward pressure on prices. Conversely, by increasing it, they stimulate demand and thus push prices up. They have several tools at their disposal to pursue their objectives. While central banks have a whole arsenal at their disposal to steer monetary policy, the best-known way of influencing prices is through key interest rates. A policy of low (high) key interest rates is designed to ease (tighten) financing conditions and, in principle, helps to stimulate (curb) economic activity and thus maintain upward (downward) pressure on prices.
The reference rate is usually the interest rate set by a central bank at which a commercial bank refinances itself (generally in exchange for collateral). In some cases, the deposit rate may be considered the reference rate; this interest rate corresponds to the level of remuneration for certain categories of commercial bank deposits with a central bank.
The chart below shows the evolution of reference rates in the eurozone, which remained at rock bottom for a long time before rising with inflationary pressures in 2022-2024, and which are now entering a new downward cycle as fears about price growth dissipate.
Source: European Central Bank, Banque de France
These rates, which serve as a benchmark, tend to spread throughout the economy, with commercial banks adjusting the rates they charge for lending to the level of key interest rates. While commercial banks can also obtain financing or lend on the interbank market, where they trade short-term financial assets, this market is also influenced by central bank decisions. Since commercial banks can borrow or lend from a central bank or on the interbank market, arbitrage between supply and demand ensures that interbank interest rates fluctuate around the key rates set by a central bank.
Furthermore, changes in key interest rates also affect exchange rates. By raising key interest rates, central banks make investments in the currency they are responsible for relatively more attractive. This increases demand for that currency, which leads to a rise in the exchange rate and, in principle, an appreciation of the currency.
However, central banks may be constrained in their use of interest rates, particularly when particularly weak growth prevents them from raising rates too much to combat inflation, or when lower rates are not enough to revive the economy and stimulate healthy price growth. In recent years, they have equipped themselves with a number of complementary tools that they use when conventional policies reach their limits.
Unconventional measures: central banks’ weapons in times of crisis
At the height of the 2008 financial crisis, in addition to lowering its key interest rate to a historically low level (close to 0%, the zero lower bound) to support the economy, the US Federal Reserve, followed by other central banks in developed countries, launched a program to purchase financial assets with the aim of continuing to ease financing conditions despite rock-bottom rates by weighing on short- and long-term bond interest rates.
This technique, known as quantitative easing (QE) , was first introduced in Japan in the early 2000s. It involves a central bank buying back or refinancing a large quantity of financial assets, particularly sovereign bonds, on the secondary markets in order to increase their price and thus lower interest rates. By lowering the yield on these assets, central banks encourage investors to shift to other financial assets, such as the equity or even credit markets, making them relatively more profitable. As a result, equity markets often become more attractive during periods of monetary easing, and valuations rise.
The chart below shows that the monetary tightening cycles of 2015-2019 and 2022-2024 in the United States were associated with lower average annual growth in the S&P 500 benchmark index than during the monetary easing cycle of 2019-2022. This trend of better performance by equity indices during periods of monetary easing has been observed frequently over time.
Source: Federal Reserve Bank of St. Louis
Conversely, the recent period of inflation has led central banks to slow down or even halt their purchases and allow bonds to mature without reinvesting the value of the securities. This quantitative tightening ( QT) has the opposite effect on the markets to that of quantitative easing.
Central banks can also influence financial markets by influencing expectations through forward guidance (see this article by BSI Economics), i.e., clear communication on their future actions in order to guide and stabilize the expectations of economic agents. For this channel of expectations to work, monetary policy must be considered credible and central banks must be seen as independent. Thus, if a central bank that is considered credible announces that it will not raise its key rates for a certain period, interest rates at that horizon should align with short-term rates, as agents expect rates at that maturity to remain unchanged.
The end of QT and its uncertain consequences
While the major central banks have learned to navigate recent crises, first by significantly easing their policies during the pandemic and then by tightening them during the inflationary period, and have deployed numerous tools to deal with these episodes, they now find themselves in an unprecedented situation in which a decline in key interest rates and quantitative tightening, two phenomena that are in principle opposite, coincide. This raises questions about how the various asset classes concerned will react in the coming months.
The case of the United States is particularly noteworthy in light of President-elect Trump’s announcements of increased public deficit, even as the Federal Reserve is engaged in an accelerated reduction of its balance sheet (see this Killer Chart from BSI Economics). An entire chapter of the latest book by BSI Economics (published by Dunod in 2024), entitled « Quel avenir pour la politique monétaire ? » (What future for monetary policy?), explores this subject in order to provide insights into the future role of our central banks, which are likely to play an increasingly decisive role in areas that ultimately extend beyond the monetary sphere alone.
[1] In developed economies, central banks generally aim for consumer price growth to be close to a target of +2% year-on-year.
[2] Central banks can also conduct monetary policy by adjusting the level of reserve requirements, but also by adjusting their securities portfolios throughopen market operations, or by using forward guidance to steer market expectations.
[3] In the eurozone, for example, reserve requirements in the form of deposits do not earn interest, unlike excess reserves (see this BSI Economics article on the subject).
[4] As a reminder, bond yields and prices always move in opposite directions.
