What Is a Central Bank? The Institution That Sets the Price of Money

The simplest description is that it is the bank that commercial banks use. Barclays and Lloyds hold accounts there, settle payments between themselves by moving balances in those accounts, and borrow from it when short. Those balances, together with the physical notes it issues, are the ultimate form of money in the economy, which is why it can create money in a way no other institution can: when it buys an asset, it pays by crediting a bank's account with it, and the money did not exist beforehand. The first were not designed as anything so grand. The Swedish Riksbank of 1668 and the Bank of England of 1694 were founded to lend to governments at war, and their wider role grew by accident over two centuries as they turned out to be the only bodies able to steady a panic.

A modern one carries several jobs, not all of which sit comfortably together:

• •Setting the policy interest rate, the rate at which banks borrow from and lend to it, which transmits into every other rate in the economy and is the main tool for controlling inflation
• •Issuing banknotes and managing the physical currency
• •Acting as lender of last resort to solvent banks that cannot raise cash, which is the function that stops a panic becoming a collapse
• •Supervising banks and setting the capital they must hold, in countries where that is not a separate agency
• •Running the payment system through which large transfers between banks actually settle
• •Holding the country's foreign currency reserves and, in some systems, managing the exchange rate
• •Acting as banker to the government, holding its account and handling its debt issuance

Most are legally independent of the elected government in their day-to-day decisions, which is unusual for a body with that much power and is a deliberate response to a specific failure. A government facing an election has a standing incentive to cut rates and let the economy run hot, since the benefit arrives before the vote and the inflation afterwards, and if everyone expects that, inflation expectations rise and the policy stops working. Handing the decision to officials with a fixed mandate, a long term and no election to fight is a way for a government to tie its own hands credibly. New Zealand pioneered the modern version in 1989 with an explicit inflation target, the Bank of England was given operational independence in 1997, and the great majority of countries followed. The arrangement has critics, since unelected officials making distributive decisions is a real democratic problem, and it has failure cases, most obviously where independence exists on paper and not in practice.

The oldest function is the one that matters in a crisis. A bank is solvent but illiquid when its assets are good and simply cannot be sold fast enough to meet depositors demanding cash, and in that situation a panic is self-fulfilling: the run destroys a bank that would have been fine. Walter Bagehot set out the rule in 1873, which is to lend freely, against good collateral, at a penalty rate, so that solvent institutions survive and reckless ones still pay for the rescue. The principle was applied on an enormous scale in 2008 and again in 2020, and the difficulty is always the same, since the distinction between an institution that is short of cash and one that is actually bankrupt is much clearer in a textbook than at two in the morning, and lending to the second kind rewards exactly the behaviour that caused the crisis.

After 2008 the policy rate in much of the rich world hit zero and could go no lower in any useful way, and the response was to buy assets directly, mostly government bonds, with newly created reserves, which is what quantitative easing means. The aim was to push down long-term rates and push investors into riskier assets, and the effect was to expand balance sheets to a size no one had contemplated, with the Bank of England holding a portfolio that peaked near 40 percent of national income. The verdict is still contested: it probably prevented a deeper slump, it certainly raised the prices of houses and shares, which are owned mostly by people who already had them, and unwinding it has proved harder than starting it. The inflation of 2021 to 2023 then reopened the older argument about whether these institutions had been too slow, and whether a mandate focused on inflation alone can survive a decade in which they were asked to manage employment, financial stability and climate risk as well.

It is the bank that other banks hold accounts at, which gives it the power to create money and makes its policy rate the anchor for every other rate in the economy. It issues currency, runs the payment system, supervises banks, holds reserves and lends freely against good collateral in a panic, a rule set out by Bagehot in 1873. Most are legally independent because governments cannot credibly promise not to inflate before an election, and since 2008 the exhaustion of interest rate policy has pushed them into asset purchases on a scale that has expanded their balance sheets and their political exposure.