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Why do we have a Central Bank?

August 19, 2019

Why do we have central banks? Asking such a broad question to ten economists is sure to elicit at least twenty different answers. However, we argue that, in its most basic form, the main purpose of having an independent institution in charge of monetary policy is to smooth out the inevitable ups and downs of business cycles so that a society and its people can achieve their full growth potential without the adverse effects of wild economic fluctuations.

 

Looking at U.S. data going back 164 years, we do observe a significant and gradual reduction in the vagaries of the economy after the creation of the Federal Open Market Committee (FOMC) in 1935. During the previous 80 years, U.S. citizens spent nearly half (44%) their time in recessions. In contrast, only 13% of the following 84 years saw the economy fall back into recessionary periods, each of which lasted only half as long, on average, as before (7 quarters pre-FOMC versus 3.6 quarters post-FOMC) (Chart 5)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Living in a more predictable and less volatile economic environment understandably made life easier for businesses (and households!) looking to invest in value-added projects spanning multiple years, or even decades. Consequently, U.S. equities went from growing at a poor 1.6% real annualized rate before 1935 to 5.7% thereafter, a much better representation of their long-run potential (Chart 6).

 

Of course, such a track record doesn’t shield the Federal Reserve from critics, with none other than the U.S. President leading the charge recently, going so far as to tweet on July 5 that “our most difficult problem is not our competitors, it is the

Federal Reserve.” To be fair, Trump was not completely mistaken when he later added that “If we had a Fed that would lower interest rates, we would be like a rocket ship.” The problems are that rockets are not known for their smooth landings, and an economy that is running too fast is likely to crash at the slightest turn—precisely what the Fed wants to avoid.

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