The past several years have been extraordinarily challenging for central bank policy. Public debt has climbed to worrying levels, inflation is well below target and many other structural forces are acting adversely. In the face of these forces, central banks need to be flexible.
One way to do that is by changing their policies to give themselves more room for manoeuvre when they decide to exit their policies. Another is to make their policy more transparent, to ease communication with the public and enhance credibility. But both are hard to do in practice.
In general, central banks operate by setting a target for the interest rate that they would like to see in the economy. This is called the policy rate. It may be a short-term rate (e.g. overnight) or a longer-term rate that is reviewed on a monthly or quarterly basis by a policy committee. The central bank will try to keep the policy rate close to its inflation target while balancing the need to support growth and employment.
A second strategy involves adjusting the size of the money supply. To do that, the central bank buys financial instruments from the market. This increases the amount of cash in the system by adding to the reserves that banks must maintain at the central bank (e.g. buying treasuries or agency mortgage-backed securities). Purchasing corporate bonds or stocks can also have the same effect. This type of policy is commonly known as quantitative easing. The key to this strategy is the confidence of market agents in the long-run credibility of the central bank’s commitment to low inflation. This is a big reason why credible policy announcements (such as Mario Draghi’s “whatever it takes” statement during the GFC or the Fed’s many steps in response to the Covid-19 pandemic) play a critical role.