CENTRAL BANKING

5.0 Introduction

The Central Bank of Kenya (CBK), like most other central banks around the world, is entrusted with the responsibility of formulating and implementing monetary policy directed to achieving and maintaining low inflation as one of its two principal objectives; the other being to maintain a sound market-based financial system. Since its establishment in 1966, the CBK has essentially used a monetary –targeting framework to pursue the inflation objective. The use of this monetary
policy strategy has been and continues to be based on the presumption that money matters, that the behavior of monetary aggregates has major bearing on the performance of the economy, particularly on inflation.

5.1 What are the main functions of a central bank?

A central bank can generally be defined as a financial institution responsible for overseeing the monetary system for a nation, or a group of nations, with the goal of fostering economic growth without inflation.

The main functions of a central bank can be listed as follows:

1. The central bank controls the issue of notes and coins (legal tender). Usually, the central bank will have a monopoly of the issue, although this is not essential as long as the central bank has power to restrict the amount of private issues of notes and coins.
2. It has the power to control the amount of credit-money created by banks. In other words, it has the power to control, by either direct or indirect means, the money supply.
3. A central bank should also have some control over non-bank financial intermediaries that provide credit.
4. Encompassing both parts 2 and 3, the central bank should effectively use the relevant tools and instruments of monetary policy in order to control: Credit expansion; Liquidity; and The money supply of an economy.
5. The central bank should oversee the financial sector in order to prevent crises and act as a lender-of-last-resort in order to protect depositors, prevent widespread panic withdrawal, and otherwise prevent the damage to the economy caused by the collapse of financial institutions.
6. A central bank acts as the government’s banker. It holds the government’s bank account and performs certain traditional banking operations for the government, such as deposits and lending. In its capacity as banker to the government it can manage and administer the country’s national debt.
7. The central bank also acts as the official agent to the government in dealing with all its gold and foreign exchange matters. The government’s reserves of gold and foreign exchange are held at the central bank. A central bank, at times, intervenes in the foreign exchange markets at the behest of the government in order to influence the exchange value of the domestic currency.

5.2 Major macro-economy policies

There are five major forms of economic policy (or, more strictly macroeconomic policy) conducted by governments that are of relevance. These are: monetary policy; fiscal policy; exchange rate policy; prices and incomes policy; and national debt management policy.

• Monetary policy is concerned with the actions taken by central banks to influence the availability and cost of money and credit by controlling some measure (or measures) of the money supply and/or the level and structure of interest rates.
• Fiscal policy relates to changes in the level and structure of government spending and taxation designed to influence the economy. As all government expenditure must be financed, these decisions also, by definition, determine the extent of public sector borrowing or debt repayment. An expansionary fiscal policy means higher government
  spending relative to taxation. The effect of these policies would be to encourage more spending and boost the economy. Conversely, a contractionary fiscal policy means raising taxes and cutting spending.
• Exchange rate policy involves the targeting of a particular value of a country’s currency exchange rate thereby influencing the flows within the balance of payments. In some countries it may be used in conjunction with other measures such as exchange controls, import tariffs and quotas.
• Prices and incomes policy is intended to influence the inflation rate by means of either statutory or voluntary restrictions upon increases in wages, dividend and/or prices.
• National debt management policy is concerned with the manipulation of the outstanding stock of government debt instruments held by the domestic private sector with the objective of influencing the level and structure of interest rates and/or the availability of reserve assets to the banking system.

5.3 Monetary policy

Monetary policy relates to the control of some measure (or measures) of the money supply and/or the level and structure of interest rates. In recent years, much greater emphasis has been placed on monetary policy within a government‟s policy package.

This is because broad consensus has emerged that suggest that price stability is an essential precondition for achieving the central economic objective of high and stable levels of growth and employment. Monetary policy is viewed as the preferred policy choice for influencing prices.

Although traditionally the choice of monetary policy over fiscal policy as the main policy tool was viewed as a matter of ideological choice, nowadays it is seen more as a pragmatic solution. As it is widely recognized that high and variable inflation harms long-term growth and employment, policymakers have tended to focus on those policies that appear to be most successful in dampening inflationary pressures.

Price stability, therefore, has become a key element of economic strategy, and monetary policy is widely accepted as the most appropriate type of policy to influence prices and price expectations. The preference for using monetary policy over other types of policy relates to two main factors – the role of the monetary authorities (central banks) as sole issuers of banknotes and bank reserves (known as the monetary base) and the long run neutrality of money.

The central bank is the monopoly supplier of the monetary base and as a consequence can determine the conditions at which banks borrow from the central bank. The central bank can influence liquidity in the short-term money markets and so can determine the conditions at which banks buy and sell short-term wholesale funds. By influencing short-term money market rates, the central bank influences the price of liquidity in the financial system and this ultimately can impact on various economic variables such as output or prices.

In long run a change in the quantity of money in the economy will be reflected in a change in the general level of prices but it will have no permanent influence on real variables such as the level of (real) output or unemployment. This is known as the long-run neutrality of money. The argument goes that real income or the level of unemployment are, in the long term, determined solely by real factors, such as technology, population growth or the preferences of economic agents. Inflation is therefore solely a monetary phenomenon.

As a consequence in the long run:

• A central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices.
• Economic growth cannot be increased though monetary expansion (increased money supply) or by keeping short-term interest rates at levels inconsistent with price stability. In the past it has been noted that long periods of high inflation are usually related to high monetary growth. While various other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over the short period, over time these influences can be offset by a change in monetary policy.

5.4 Monetary policy functions of a central bank

The most important function of any central bank is to undertake monetary control operations. Typically, these operations aim to administer the amount of money (money supply) in the economy and differ according to the monetary policy objectives they intend to achieve.

5.4.1 Monetary policy objectives

Monetary policy is one of the main policy tools used to influence interest rates, inflation and credit availability through changes in the supply of money (or liquidity) available in the economy. It is important to recognize that monetary policy constitutes only one element of an economic policy package and can be combined with a variety of other types of policy (e.g., fiscal policy) to achieve stated economic objectives.

Historically, monetary policy has, to a certain extent, been subservient to fiscal and other policies involved in managing the macro-economy, but nowadays it can be regarded as the main policy tool used to achieve various stated economic policy objectives (or goals).

The main objectives of economic (and monetary) policy include:

1. High employment – often cited as a major goal of economic policy. Having a high level of unemployment results in the economy having idle resources that result in lower levels of production and income, lower growth and possible social unrest. However, this does not necessarily mean that zero unemployment is a preferred policy goal. A certain level
of unemployment is often felt to be necessary for the efficient operation of a dynamic economy. It will take people a period of time to switch between jobs, or to retrain for new jobs, and so on – so even near full employment there maybe people switching jobs who are temporarily out of work. This is known as frictional unemployment.

In addition, unemployment may be a consequence of mismatch in skills between workers and what employers want – known as structural unemployment. (Typically, although structural unemployment is undesirable monetary policy cannot alleviate this type of unemployment). The goal of high employment, therefore, does not aim to achieve zero unemployment but seeks to obtain a level above zero that is consistent with matching the demand and supply of labour. This level is known as the natural rate of unemployment.

(Note, however, that there is much debate as to what is the appropriate natural level of unemployment – usually a figure of around 4% is cited as the appropriate level)

2. Price stability – considered an essential objective of economic policy, given the general wish to avoid the costs associated with inflation. Price stability is viewed as desirable because a rising price level creates uncertainty in the economy and this can adversely affect economic growth. Many economists (but by no means all) argue that low inflation
is a necessary prerequisite for achieving sustainable economic growth.

3. Stable economic growth – provides for the increases over time in the living standards of the population. The goal of steady economic growth is closely related to that of high employment because firms are more likely to invest when unemployment is high and firms have idle production they are unlikely to want to invest in building more plants and
factories. The rate of economic growth should be at least comparable to the rates experienced by similar nations.

4. Interest rate stability – a desirable economic objective because volatility in interest rates creates uncertainty about the future and this can adversely impact on business and consumer investment decisions (such as the purchase of a house). Expected higher interest levels deter investment because they reduce the present value of future cash flows
to investors and increase the cost of finance for borrowers.

5. Financial market stability – also an important objective of the monetary authorities. A collapse of financial markets can have major adverse effects on an economy. The US Wall Street Crash in 1929 resulted in a fall of manufacturing output by 50 percent and an increase in unemployment to 25 to 30 percent of the US work force by 1932. (Over 11,000 banks closed over this period.)

Note that financial market stability is influenced by stability of interest rates because increases in interest rates can lead to a decrease in the value of bonds and other investments resulting in losses in the holders of such securities.

6. Stability in foreign exchange markets – has become a policy goal of increasing importance especially in the light of greater international trade in goods, services and capital. A rise in the value of a currency makes exports more expensive, whereas a decline in the value of a currency leads to domestic inflation. Extreme adverse movements in a currency can therefore have a severe impact on exporting industries and can also have serious inflationary consequences if the economy is open and relatively dependent on imported goods. Ensuring the stability of foreign exchange markets is therefore seen as an appropriate goal of economic policy.

At first glance it may appear that all these policy objectives are consistent with one another, however conflicts do arise. The objective of price stability can conflict with the objectives of interest rate stability and full employment (at least in the short-run) because as an economy grows and unemployment declines, this may result in inflationary pressures forcing up interest rates. If the monetary authorities do not let interest rates increase this could fuel inflationary pressures, yet if they do increase rates then unemployment may occur. These sorts of conflicts create difficulties for the authorities in conducting monetary and other macroeconomic policy.

Typically, the most important long-term monetary target of a central bank is price stability that implies low and stable inflation levels. Such a long-term goal can only be attained by setting short-term operational targets. Operational targets are usually necessary to achieve a particular level of interest rates, commercial banks‟ reserves or exchange rates. Often they are complemented by intermediate targets such as a certain level of long-term interest rates or broad money growth (monetary aggregates). In choosing the intermediate targets, policymakers should take into account the stability of money demand and the controllability of the money aggregate. The chosen target should also be a good indicator of the effect of the monetary policy decision on the price stability target.

5.4.2 Instruments of monetary policy

In the past, it was common for central banks to exercise direct controls on bank operations by setting limits either to the quantity of deposits and credits (e.g., ceilings on the growth of bank deposits and loans), or to their prices (by setting maximum bank lending or deposit rates). As a result of the significant financial liberalization process aimed at achieving an efficient allocation of financial resources in the economy, there has been a movement away from direct monetary
controls towards indirect ones.

Indirect instruments influence the behaviour of financial institutions by affecting initially the central banks‟ own balance sheet. In particular the central bank will control the price or volume of the supply of its own liabilities (reserve money) that in turn may affect interest rates more widely and the quantity of money and credit in the whole banking system.
The two most significant assets of the Central Bank are debt securities followed by loans and advances. On the liability side, debt securities are again the largest proportion, followed by deposits by central banks and deposits by banks and building societies.

The indirect instruments used by central banks in monetary operations are generally classified
into the following:

• Open market operations (OMOs);
• Discount windows
• Reserve requirements.

Debt securities and open market operations

Debt securities are mainly represented by Treasury securities (i.e., government debt) that central banks use in open market operations are the most important tools by which central banks can influence the amount of money in the economy.

Although the practical features of open market operations may vary from country to country, the principles are the same: the central bank operates in the market and purchases or sells government debt to the non-bank private sector. In general, if the central bank sells government debt the money supply falls (all other things being equal) because money is taken out of bank accounts and other sources to purchase government securities. This leads to an increase in short term interest rates. If the government purchases (buys-back) government debt this results in an injection of money into the system and short-term interest rates fall. As a result, the central bank can influence the portfolio of assets held by the private sector. This will influence the level of liquidity within the financial system and will also affect the level and structure of interest rates.

The main advantages of using open market authorities to influence short-term interest rates are as follows:

• They are initiated by the monetary authorities who have complete control over the volume of transactions;
• Open market operations are flexible and precise – they can be used for major or minor changes to the amount of liquidity in the system;
• They can easily be reversed;
• Open market operations can be undertaken quickly.

Open market operations are the most commonly used indirect instruments of monetary policy in developed economies. One of the main reasons for the widespread use of market operations relates to their flexibility in terms of both the frequency of use and scale (i.e., quantity) of activity. These factors are viewed as essential if the central bank wishes to fine-tune its monetary policy. In addition, OMOs have the advantage of not imposing a tax on the banking system.

Loans to banks and the discount window
The second most important monetary policy tool of central bank is the so-called „discount window‟ (in the United Kingdom this tool is often referred to as „standing facilities‟). It is an instrument that allows eligible banking institutions to borrow money from the central bank, usually to meet short-term liquidity needs. Discount loans to banks account for a relatively large proportion of a central bank’s total assets.

By changing the discount rate, that is, the interest rate that monetary authorities are prepared to lend to the banking system, the central bank can control the supply of money in the system. If, for example the central bank is increasing the discount rate, it will be more expensive for banks to borrow from the central bank so they will borrow less thereby causing the money supply to decline. Vice versa, if the central bank is decreasing the discount rate, it will be cheaper for banks to borrow from it so they will borrow more money. Manipulation of the discount rate can therefore influence short-term rates in the market.

Direct lending to banks can also occur through the central bank’s lender-of-last-resort (LOLR) function. By acting as a lender-of-last-resort the central bank provides liquidity support directly to individual financial institution if they cannot obtain finance from other sources. Therefore it can help to prevent financial panics.

Reserve requirements

Banks need to hold a quantity of reserve assets for prudential purposes. If a bank falls to its minimum desired level of reserve assets it will have to turn away requests for loans or else seek to acquire additional reserve assets from which to expand its lending. The result in either case will generally be a rise in interest rates that will serve to reduce the demand for loans. The purpose of any officially imposed reserve requirements is effectively to duplicate this process. If the authorities impose a reserve requirement in excess of the institutions‟ own desired level of reserves (or else reduce the availability of reserve assets) the consequence will be that the institutions involved will have to curtail their lending and/or acquire additional reserve assets. This will result in higher interest rates and a reduced demand for loans that, in turn, will curb the rate of growth of the money supply.

By changing the fraction of deposits that banks are obliged to keep as reserves, the central bank can control the money supply. This fraction is generally expressed in percentage terms and thus is called the required reserve ratio: the higher the required reserve ratio, the lower the amount of funds available to the banks. Vice versa, the lower the reserve ratio required by the monetary authorities, the higher the amount of funds available to the banks for alternative investments.

The advantage of reserve requirements as a monetary policy tool is that they affect all banks equally and can have a strong influence on the money supply. However, the latter can also be a disadvantage, as it is difficult for the authorities to make small changes in money supply using this tool. Another drawback is that a call for greater reserves can cause liquidity problems for banks that do not have excess reserves. If the authorities regularly make decisions about changing reserve requirements it can cause problems for the liquidity management of banks. In general, an increase in reserve requirements affects banks‟ ability to make loans and reduces potential bank profits because the central bank pays no interest on reserves.

Reserve requirements are often referred to as instruments of portfolio constraint. It means that they may be imposed by the authorities on the portfolio structure of financial institutions, with the purpose of influencing credit creation and, possibly, the type of lending taking place.

Other instruments

1. Moral suasion
Moral suasion refers to the range of informal requests and pressure that the authorities may exert over banking institutions. The extent to which this is a real power of the authorities relative to direct controls is open to question, since much of the pressure that the authorities would exert involves the institutions having to take actions that might not be in the bank’s commercial interests. However, the position and potential power of the authorities probably provides them
with some scope to use moral suasion, which may perhaps be utilised most effectively in the context of establishing lending priorities rather than absolute limits to credit creation.

2. Direct controls
Direct controls involve the authorities issuing directives in order to attain particular intermediate targets. For example, the monetary authorities might impose controls on interest rates payable on deposits, may limit the volume of credit creation or direct banks to prioritise lending according to various types of customer.

Although these direct controls have the benefits of speed of implementation and precision, they are discriminating towards the institutions involved and are likely to lead to disintermediation as both potential borrowers and potential lenders seek to pursue their own commercial interests.

Their use, therefore, is perhaps best reserved for short-term requirements not least since their effectiveness will tend to decline the longer they are applied. Such controls, however, are widely used in many developing countries where the authorities may force banks to (say) lend a certain percentage of loan-book to „priority sectors‟.

3. Gentlemen’s agreements
These are voluntary agreements between the central bank and banks, aimed at improving monetary conditions in the economy. In Tanzania such agreements have been used between the central bank and the largest commercial bank in an effort to lower the spread on interest rates.

5.5 Why do banks need a central bank?

The banking sectors of most countries have pyramid structure where a central bank is at the apex and the ordinary banking institutions are at the base of the pyramid. Central banks can also be thought of as „super-banks‟, at the centre of the financial system, responsible for both „macro‟ functions, such as monetary policy decisions; and „micro‟ functions, including the lender-of-last resort (LOLR) assistance of the banking sector. Over time the role and functions of central banks have developed and evolved, as has the environment in which banks operate. Liberalization, financial innovation and technology have contributed to major changes in the operating environment.

The lender-of-last-resort (LOLR) function of the central bank
In its role as a the lender-of-last-resort (LOLR), the central bank will provide reserves to a bank (or banks) experiencing serious financial problems due to either a sudden withdrawal of funds by depositors or to a situation where the bank has embarked on highly risky operations and thus cannot find liquidity anywhere else (i.e., no other institutions will lend to a bank considered near collapse).

It is clear that the central bank will extend credit to an illiquid bank to prevent its failure only in exceptional situations and in doing so it also carries out a „macro‟ function by preventing potential financial panics. However, the central bank cannot guarantee the solvency of every banking institution in a country. This is because it would encourage bankers to undertake undue risk and operate imprudently, especially if banks knew that they would always be bailed out (by taxpayers‟ money) were they to become insolvent. In other words, the security of the LOLR function could induce or increase moral hazard in banks‟ behaviour.

5.6 Should central banks be independent?

In recent years there has been a significant trend towards central bank independence in many countries and the issue has generated substantial debate all over the world. Theoretical studies seem to suggest that central bank independence is important because it can help produce a better monetary policy. For example, an extensive body of literature predicts that the more independent a central bank, the lower the inflation rate in an economy.

Central bank independence can be defined as independence from political influence and pressures in the conduct of its functions, in particular monetary policy. It is possible to distinguish two types of independence: goal independence, that is, the ability of the central bank to set its own goals for monetary policy (e.g., low inflation, high production levels); and
instrument independence, that is, the ability of the central bank to independently set the instruments of monetary policy to achieve these goals .

It is common for a central bank to have instrument independence without goal independence; however, it is rare to find a central bank that has goal independence without having instrument independence. In the United Kingdom, for example, the Bank of England is currently granted instrument independence and practices what is known as inflation targeting. This means that it is the government that decides to target the inflation rate and the Bank is allowed to independently
choose the policies that will help to achieve that goal. Such a situation is only acceptable in a democracy because the Bank is not elected and thus goals should only be set by an elected government.

While central bank independence indicates autonomy from political influence and pressures in the conduct of its functions (in particular monetary policy), dependence implies subordination to the government. In the latter case, there is a risk that the government may „manipulate‟ monetary policy for economic and political reasons. It should be noted, however, that all independent central banks have their governors chosen by the government; this suggests that to some extent central banks can never be entirely independent.