Central bankers are sometimes known as the high priests of finance. That is because they control high-powered money, commonly known as the monetary base, or the sum of currency in circulation plus commercial bank deposits with them. By buying government bonds from banks or the market, which expands central bank balance sheets, the commercial banks’ reserves rise, improving market liquidity and therefore reducing short-term interest rates.
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In effect, central banks affect market sentiment by expanding their balance sheets, which is also known as quantitative easing. Buying long-term bonds lowers their yields while increased liquidity lowers short-term rates, thus changing the whole interest rate curve. Interest rates rise when central banks tighten liquidity, affecting asset prices and having an effect on the real economy by influencing economic growth and jobs.
Central banks seek to implement monetary policy to maintain price and financial stability. Today, this is seen as a professional and technical job requiring autonomy of operations, if not policy independence.
However, one should never forget that the first central bank was created in Sweden, in 1668, to finance the government and operate the bank clearing house. When the currency was pegged against gold – the gold standard – central banks operated a simple rule: no gold, no monetary creation.
However, governments quickly found out that central banks can fund huge government deficits at the risk of inflation. Governments with high debt levels do not like high interest rates, since there comes a point where the fiscal debt interest burden becomes unsustainable.
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Thus, central bankers have the unpleasant task of what William McChesney Martin – the US Federal Reserve chairman from 1951 to 1970 – called taking away the punchbowl just as the party gets going. Namely, their job is to tell those in charge of finance what they do not want to hear: the need for fiscal tightening.