The central bank’s 2 levers
A central bank has a job and 2 levers: the interest rate and the balance sheet. How it uses them through the cycle, and why markets react to every inflation and jobs number.
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In this video
- The Fed’s job is stable prices and maximum employment: in practice, inflation around 2% and as many people working as the economy can handle.
- Lever 1 is the interest rate. A cut makes borrowing cheaper and speeds the economy up. A hike slows spending and cools inflation.
- Lever 2 is the balance sheet. QE buys bonds with new reserves and pushes long-term rates down. QT lets those bonds run off.
- Watch what the bank is fighting, inflation or unemployment, and you know which lever comes next.
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Key terms
- Central bank
- The institution that sets a country’s key interest rate and controls the money supply, like the Fed, the ECB or the Bank of England.
- Key interest rate
- The rate a central bank sets for lending to banks. It drives borrowing costs across the economy and is one of the biggest drivers of a currency.
- Quantitative easing (QE)
- A central bank creates new money to buy bonds. It pushes yields down and adds money to the system, which usually weakens the currency.
- Tightening and easing
- Tightening means raising rates or reducing the money supply. Easing means cutting rates or adding money to the system.