Fundamental Analysis (lesson11)

In this section, we will look at Central Bank Tools.

When a central bank is decided that action is needed they must decide what action to implement and how strongly to do it.
Understanding this section will help you interpret news reports and research articles each day and become tuned into markets and most importantly actions that bank takes in such a way to be able to take advantage.
Let's refresh our memory what central bank tools can use to control price stability and monetary policy.
We will break the tools down in 6 categories.
The most important thing to understand about central bank monetary policy tools is they are interrelated to basically achieve the same result wich is to control inflation and economy, ensure growth and keep the value of the currency stable.
If they didn't do this entire banking system would collapse.

The first core element central bank looks to control is the monetary base.
The monetary base is the amount of commercial banks reserves held the central bank plus the amount of total currency circulated in public domain.
In order to control the monetary base is central bank will use open market operations, and you will remember this is simply buying and selling bonds by the bank on the open market.
We looked at how Federal Reserve use something REPOS to conduct this buying and selling.
While ECB in Europe use refinancing operations.
When conducting your daily research you will very often come to terms like REPOS or LTRO.
All this term simply relate to the regular ongoing operations by various central banks around the world to keep the monetary base steady.
This generally has no impact on the market because they are so regular.
For example, ECB conducts his operations weekly and sometimes daily but it's worth understanding what going on when you read this information and how to approach it.

The next concept is Reserve Requirements.
The central bank is in charge of controlling all the commercial banks.
One of the ways it exercises this control is to require this banks to hold a certain amount of assets as liquid cash so it can be used anytime.
By doing this the bank control how much money is available for loans and financial system as a whole.
Therefore if the bank is trying to get the money into the system this is one simple way to achieve that.
Changing reserve requirements to often can have negative consequences creating volatility and fears in the system.
This kind of volatility can disrupt the banking system.
One of the most useful features of central banks tool kit is something called discount window lending.
The purpose of this tool is alow commercial banks a means of borrowing money quickly at below market interest rates.
This is very useful if the bank is going through temporary liquidity issue. By keeping this supply of money available to commercial banks the central bank ensures the stable economic environment that allows us savings and investments wich encourages growth and employment.

Next, we have Interest Rates.
FX world revolves around interest rates.
Interest rates are used as a tool when the central bank wants long term effect on inflation rate or money supply.

The next core element of central bank toolkit is Currency Board.
A currency board is basically where one nation pegs the value of their currency to devalue the another nation's currency.
The local currency is backed by foreign one and if the local bank wants to grow their money supply they first need to increase the amount of foreign currency they have in reserve.
There are 3 reasons the central bank may decide to do this.
First to import the credibility of the foreign nations monetary policy.
Second to maintain fixed exchange rate with foreign nation
A third to establish credibility with exchanges.
A currency board is practically the same as gold standard.
This is tool applied by smaller or developing central banks.
Tolls can be abandoned any time.

 Final concept we will look at is unconventional monetary policy.
This is tools used when interest rates are already at 0 but it's not having a desired effect.
For Example the rate could be at 0 but the economy is still heading to deflation wich we know is very bad.
In this scenario the bank may implement Quantitative Easing wich is basically printing the money to inject into the system via government bonds.
The impact to this is to devalue the currency encourage growth and to stimulate inflation.

Another policy that can be used when interest rates are at 0 is something called Credit Easing.
In credit easing, the central bank will purchase assets from the private sector to improve liquidity and access to credit.
The Federal Reserve performed credit easing in 2010 when it bought 1,2 trillion dollars worth of mortgage securities.

The final tool is Signaling or Language.
This is simply when the central bank tries to signal markets what they will be doing over coming months in terms of monetary policy.
The reason the bank tries to do this is to get desired impact immediately to without a lot of action.
It usually depends on central banks credibility with the market, if the bank is known to be unreliable very often the use of language will fail and a market will not trade as central bank wishes.
Another purpose of this language is to offer stability to the market.
All of this tools are used around the world and our job is to identify what central bank mandates are, what indicators are they concerned with and what tools will they use in order to deal with any issue they have.
The whole FX markets are based around this concept of central banks focus, and when you predict the next central banks move you are on the way to profit consistently.

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