Central banks

A central bank is the institution responsible for the monetary policy of a country or currency area: it issues the currency, steers interest rates and the money supply, and acts as the bank for commercial banks. Central banks are among the most influential market participants. This entry looks at two of them in detail: the European Central Bank (ECB) and the US Federal Reserve (Fed). These two hold a special position because traders follow their decisions particularly closely. However, other central banks – such as the Bank of Japan, the Bank of England or the Swiss National Bank – also play a major role.

ECB – European Central Bank

The European Central Bank, based in Frankfurt am Main, was established in June 1998 to prepare for the introduction of the euro in January 1999. It is the joint monetary authority of the EU member states that have adopted the euro.

Structure of the ECB

Under Article 106 of the Maastricht Treaty (composition of the ESCB; legal personality), the European System of Central Banks (ESCB) consists of the ECB itself and the national central banks of the EU member states. The ECB and the national central banks of the member states of Economic and Monetary Union (EMU) – the euro area – together form the Eurosystem. Each national central bank is represented by its governor. The ECB's decision-making body is the Governing Council, which is made up of the members of the Executive Board and the governors of the euro-area national central banks. Each voting member has one vote; since 2015, the governors have exercised their voting rights on a rotating basis. In the event of a tie, the President of the ECB has the casting vote.

The Executive Board consists of the President, the Vice-President and four other members. They are appointed by the European Council for a non-renewable term of eight years, after consultation with the European Parliament and the Governing Council. The President chairs both the Governing Council and the Executive Board and presents the monetary policy decisions to the public. Mario Draghi, for example, was President from 2011 to 2019, with Vítor Constâncio serving as Vice-President from 2010 to 2018; Christine Lagarde took office as President in November 2019. The tasks of the Executive Board are:

• preparing the meetings of the Governing Council
• implementing the decisions of the Governing Council
• carrying out monetary policy measures
• managing the ECB's day-to-day business

Article 107 of the Maastricht Treaty (independence of the ECB) is particularly important: under it, the ECB is independent of political bodies. This gives the ECB considerable power and allows it to pursue its objectives without being influenced by political goals. Since the Treaty of Lisbon, these provisions have been contained, with new article numbers, in the Treaty on the Functioning of the European Union (TFEU).

Tasks of the ECB

The ECB's core task is to maintain price stability in the euro area. With the introduction of the euro, responsibility for monetary policy passed from the national central banks – such as the Deutsche Bundesbank, which continues to exist as part of the Eurosystem – to the ECB. Since November 2014, the ECB has also directly supervised the largest banks in the euro area. The tasks of the European Central Bank were first set out in the Maastricht Treaty of 1992; Article 105 (objectives and tasks of the ESCB) lists the following:

• Price stability: keeping the price level in the euro area stable – in other words, keeping inflation low – is the ECB's most important and central task.
• Supporting the Community's economic policy: the ECB is to support the general economic policy of the Community (today the European Union) in order to promote harmonious and balanced economic development, provided this does not affect the objective of price stability.
• Liquidity: a further task is to supply the economy with sufficient money to support economic activity in the best possible way.
• Smooth payments: the ECB is to promote the smooth operation of payment systems.
• Managing foreign reserves: the central bank holds foreign reserves so that it has monetary policy instruments at its disposal. These consist of reserves in various currencies (US dollar, Japanese yen, Chinese renminbi), gold and special drawing rights. A special drawing right (SDR) is an artificial currency unit created by the International Monetary Fund (IMF); its value is based on a basket of major currencies, and IMF member countries can exchange SDRs for currencies among themselves. When managing foreign reserves, the top priority is liquidity, followed by security and, finally, return.
• Foreign exchange operations: the ECB is to conduct foreign exchange operations in line with Article 109 (agreements with third countries; exchange-rate agreements). This article covers international agreements with countries outside the EU, allowing the Community to take a common position towards them.

Fed – Federal Reserve System

The Federal Reserve System is the central banking system of the United States of America. The Federal Reserve Act of 1913 established the Fed and gave it responsibility for monetary policy.

Structure of the Fed

The Fed is made up of the following bodies:

Federal Open Market Committee (FOMC): the FOMC has 12 voting members: the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and four of the remaining eleven Reserve Bank presidents, who rotate annually. Its responsibilities include open market operations (the buying and selling of securities by the Fed) and foreign exchange policy. Above all, at its eight regularly scheduled meetings a year, the FOMC sets the target range for the federal funds rate – the Fed's key interest rate.

Board of Governors: the Board of Governors is the Fed's central governing body and is comparable to the ECB's Executive Board. It has seven members, who are nominated by the President of the United States and confirmed by the Senate. The Board's tasks include setting reserve requirements, adjusting the discount rate, supervising the twelve regional Federal Reserve Banks and maintaining relations with the central banks of other countries.

Twelve regional Federal Reserve Banks: formally, the regional Federal Reserve Banks are privately owned – their shares are held by the member banks in their districts. Nationally chartered banks are required by law to be members of the Federal Reserve System, while state-chartered banks can choose to join. Unlike ordinary shares, this stock cannot be sold or traded and does not give its holders control over monetary policy. The Reserve Banks implement the monetary and credit policy set by the Board of Governors and the FOMC.

Tasks of the Fed

The Fed's tasks include setting monetary and credit policy, supervising banks, monitoring the money supply and maintaining a well-functioning payment system. After each FOMC meeting, it announces its interest rate decision for the US dollar. The Fed is thus the US counterpart to the European Central Bank. Unlike the ECB, however, whose primary objective is price stability, the Fed has a so-called dual mandate: maximum employment and stable prices.

Why central banks matter for trading

Because central banks have enormous financial resources at their disposal, they have a decisive influence on a country's currency and economy. As a result, prices often move very sharply when important central bank news is released, such as interest rate decisions or press conferences. In the foreign exchange market in particular, central banks are the most important players. The larger the economic area a central bank covers, the greater its importance for the markets.

Traders usually try to gain an edge by looking for setups with a particularly high probability of ending in profit. The problem in the foreign exchange market is that central banks can use their tools to move markets suddenly and unpredictably when pursuing their objectives. For example, if its currency is falling sharply, a central bank can use its foreign reserves to stabilise it. Policy changes can also come as a complete surprise: in January 2015, the Swiss National Bank unexpectedly abandoned the minimum exchange rate of 1.20 francs per euro that it had defended since 2011, and the Swiss franc soared within minutes. For this reason, many traders prefer to be flat – that is, to hold no open positions – ahead of important central bank decisions rather than speculate that prices will move in the right direction.