A central bank’s monetary policy decisions have profound effects on financial conditions, ultimately impacting the economic lives of all those who spend and work in a country. The primary tool for a central bank to influence these conditions is the short-term interest rate it sets. The decision to set this rate is not driven by an inherent preference for one level of the interest rate versus another or by an attempt to control dimensions of macroeconomic activity like prices and inflation, output and employment, or designated monetary aggregates. Instead, the setting of a short-term interest rate is designed to help central banks achieve their broader goals of stability and growth.
To achieve these goals, central banks monitor financial stability and financial market conditions. They oversee banking systems, ensuring they follow regulations and maintain adequate capital reserves. They also manage payment systems and large value transfer systems. In times of crisis they act as lenders of last resort, providing emergency liquidity to the financial system. They also monitor and control inflation, striving to keep prices stable within a defined target range.
In addition to their supervisory duties, central banks communicate with the public about policy decisions and economic projections. This communication can shape market reactions. Deciphering this messaging requires attention to statement language and context, as well as careful analysis of forecasts to detect changes in the underlying message. In particular, it is important to consider how different market sectors respond to changes in rate expectations and policies, as these can have a significant impact on their respective share prices.