Money fascinates people. Either physical or electronic, gold coins or other forms, history is full of examples where money influenced the balance of powers in the world. Empires rose and were destroyed by the inability to handle money and money creation.
In modern times, money creation and money handling are in the central banks’ hands. Their role is to supervise the economy in their jurisdiction and set the right monetary policy to achieve sustained economic growth.
The financial system as we know it is centered on the U.S. dollar. As a world’s reserve currency, the U.S. dollar is the one currency that is used to clear international transactions.
Oil is sold in dollars. This puts everything into perspective, as oil has been the engine of global growth for decades and it will still be for the near to long-term future; don’t think of the revolutionary electric car industry that develops in front of our eyes.
Oil demand will rise as other industries will be heavily dependent on oil; maritime transportation and the aviation industry are strongly dependent on oil now and will be even more in the future. If the dollar will still be the world’s reserve currency, oil will be denominated in dollars.
Central Banks’ Role in Today’s Global Environment
Central banks around the world meet on a regular basis to set the interest rate for the currency they represent. A higher interest rate is hawkish for the currency, as it is the result of an expanding economy.
Therefore, when the economy expands, the central bank raises the interest rate. There are a plethora of economic indicators that offer clues before the actual interest rate changes; PMI’s (Purchasing Managers Index), GDP (Gross Domestic Product – the total value of goods and services in an economy), Retail Sales and jobs creation.
Traders know these releases and adapt to them long before the central bank meets to set the interest rate. This is a fundamental part of trading the markets.
When things go bad in an economy; the indicators mentioned above point to a recession. As a result, the central bank will meet the problem with interest rate cuts. A side effect to this will be that the currency will lose value.
As the central bank that governs over the world’s reserve currency, the Federal Reserve in the United States (the Fed) plays an important role in today’s global economy. From ancient times, any country whose money is used by others is in a privileged position.
Therefore, when the Fed is moving on rates, the whole world is listening. To this day, more than a decade after the 2008 financial crisis, the Fed remains the most proactive central bank in the world.
Federal Reserve of the United States – the Road Opener
When problems arise, someone needs to take a stance. So did the Fed in 2008, when the financial systems, as we know, were on the brink of collapse.
Movies have been made, legends were written, banks went bust, industries changed…the bottom line is that the Fed slashed the interest rates on the world’s reserve currency, the U.S. dollar to almost zero.
In doing that, it didn’t wait until the next regular meeting. It effectively cut rates overnight.
But it wasn’t enough for the economy to grow again. Yet, the main tool, interest rates, could not be lowered below zero. The reason being, that never in the monetary policy history, interest rates were set in negative territory. Not to mention on the world’s reserve currency.
Facing these constraints, the Fed went into unprecedented territory; it started to deploy so-called “unconventional measures” when it comes to central banking. The core of these measures was the quantitative easing (QE) program.
Under such a program, a central bank is buying its own government bonds (debt). The net effect is that the currency is devalued and growth picks up as inflation starts to rise. No less than four QE rounds were needed for the Fed to end the program and the economy to grow again.
Unconventional Measures in Other Parts of the World
With the Fed leading the way, other central banks around the world followed the same path. Bank of Japan (BOJ) was the most aggressive one, in the sense that its QE program was/still is bigger than the one in the United States and applied to a smaller economy.
Central banks in other jurisdictions went even further. The SNB (Swiss National Bank) and North European central banks did the unthinkable; they moved the interest rate corridor into the negative territory.
It wasn’t long until the ECB (European Central Bank) did the same. And so, the precedent was established.
To this day, it is unclear what the damage, if any, will be to these economies. The reason for that is the fact that unconventional measures are unprecedented and there’s no economic model to look after.