The #1 Biggest Misconception About The World's Central Banks

federal reserve


In the wake of Federal Reserve Chairman Ben Bernanke’s first lecture to college students on the “Origins and Mission of the Federal Reserve”, banking and fiat currency have taken the limelight of today’s chatter.But from the ensuing discussions we’ve seen both in comments and our Twitter feeds, it’s clear that critics of fiat money and the powers wielded by the Federal Reserve don’t understand one major thing about central banking: it’s not what central banks actually do that matters, but the way it’s perceived.

And in fact, it can do pretty much anything it wants.

When a central bank lowers its target interest rate—in the U.S., the federal funds rate—all it’s doing is changing the rate at which banks can lend to another. Investors have since made the connection that easier access for banks to interbank lending of reserves held at the Fed will translate into more willingness for banks to lend money in the general markets. But the central bank does not actually compel banks to lend more easily.

Or think about quantitative easing—when the Fed purchases T-bills from banks, effectively giving them the money instead. The enthusiasm generated over this move is purely based on the expectation that banks with more money will more freely lend it. They don’t have to. But then again, the Fed would never make the decision to pursue QE secretly because there would be no point.

Or look to the European Central Bank, which has been purchasing up lots of government bonds during the sovereign debt crisis. The fact that the bank is willing to interfere in the market for these securities is more important to investors than if it actually does. This is precisely why economists argue that the bank’s failure to make an unlimited commitment to purchase sovereign bonds would end the debt crisis once and for all—and it probably wouldn’t even have to buy many of those bonds to prove it.

What’s more, the ECB utilizes its deposit facility not because commercial banks are scared their money isn’t safe so much as the bank uses it to offset its bond purchases so it doesn’t increase the money supply. Really, the banks know their money is there and ECB bond buying does technically make more money exist, the central bank is just prohibiting it from entering the economy, and giving banks interest for the privilege of holding the money. The central bank and not the commercial banks determines how much money it is going to hold like this (generally, for week-long terms), just to balance its balance sheet (which isn’t really a balance sheet at all.

The Federal Reserve can do whatever it wants. There’s no need for the bank to balance its “balance sheet,” and the amount of leverage it has doesn’t actually put it at risk because it’s not held to the same standards as commercial banks. A central bank has all the data, all the policy tools, and thus all the power—if it wants to play with the numbers it can and it’s not against the rules.

The Federal Reserve is not a commercial bank, and it can’t fail like one. So don’t expect it to act like one.

NOW: Check Out Ben Bernanke’s Massive Presentation Explaining The Origins And Mission Of The Federal Reserve >

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