What Are Central Banks and How Do They Work?

Just as with a country's economy, investment performance is linked to the decisions made by the central bank. In this article, you will discover how and why you should take monetary policies into account when thinking about a strategy.

What Is a Central Bank？

Central banks are financial entities responsible for managing a currency and for forming and applying monetary policy, whether for a country or a specific economic region. These are centralized and autonomous institutions with certain privileges. In simple terms, they are the banks of the state and of commercial banks.

Although the separation between the central bank and the government is not the same in all countries—as is the case with nationalized central banks—these entities generally operate independently and maintain neutrality in the face of political influence. Because they are not subject to shareholder intervention, as in private banking, they are not dependent on market forces.

Central banks play a key role in national economies, and in some cases, their decisions can have effects beyond their borders—even globally. To understand how this happens, we analyze their most relevant functions and characteristics below.

Functions of a Central Bank

The most important function of a central bank is to maintain price stability, which means ensuring that annual price variations remain within estimated levels. In some economies, such as the Eurozone and the UK, this means keeping inflation—an increase in prices—below 2%. To exercise monetary policy and influence inflation levels and economic growth, central banks use several mechanisms:

Issuing Money

The central bank holds the exclusive right to issue currency and is responsible for distributing money into the market, whether within a single country or across a region, such as the eurozone. In this context, its important to note that the European Central Bank (ECB) operates in coordination with the national central banks of eurozone countries.

Interest Rates

Another way to control the money supply is through the reference interest rate, which the central bank sets. Interest rates represent the “cost” of money—the rate at which commercial banks can borrow from or deposit money with the central bank. Based on this rate, commercial banks set their own interest rates for the public, including savings and mortgage rates.

The Reserve Rate

Commercial banks are required to hold a portion of customer deposits as reserves with the central bank. This percentage, known as the reserve rate, is set by the central bank. By adjusting this rate, the central bank can influence the amount of money circulating in the economy—reducing liquidity when reserves are high and increasing it when reserves are low.

Official Reserves

Central banks manage the nation's foreign currency reserves, which may include assets like securities, government bonds, foreign currencies, and precious metals. These reserves help cover debt obligations and financing needs and allow the central bank to influence the exchange rate by buying or selling foreign currency to stabilize the national currencys value.

Open Market Operations

Through open market operations (OMO), central banks buy and sell financial assets in secondary markets. This is a key tool used to inject or withdraw liquidity from the market and manage the money supply.

The Most Influential Central Banks

Although each country has its own central bank, some wield greater influence over the global economy:

• U.S. Federal Reserve (Fed): The most influential central bank, given the dollars role as the leading global reserve currency.

• European Central Bank (ECB): Manages monetary policy for the eurozone and ensures the euros stability.

• Bank of England (BoE): Oversees the pound sterling and financial stability in the UK, now operating independently post-Brexit.

• Other Key Banks: The Bank of Japan, Bank of Canada, and Reserve Bank of Australia play significant roles in their respective regions.

The Impact of Central Banks and How to Operate in the Market

Regular central bank meetings are key events for both traditional investors and traders, offering critical insights into the direction of monetary policy and its potential market effects. Anticipating these announcements allows investors to adjust strategies and optimize portfolios in advance of interest rate decisions. This requires not only an analysis of economic forecasts but also awareness of the central banks leadership, political environment, and major global events such as elections or geopolitical developments like Brexit.

Generally, an increase in interest rates tends to weaken demand for stocks, bonds, and other financial assets while strengthening the local currency. Conversely, rate cuts usually boost stock and bond markets but can weaken the currency. As such, investors monitor central bank decisions closely, adjusting their exposure across foreign exchange, equities, and indices based on prevailing expectations.