Central bank policy is the way a central bank oversees and manages the money supply to stabilize a country’s economy. It does so through raising or lowering interest rates or engaging in quantitative easing. Using such tools can help reduce inflation and promote full employment, which means that more people are working and that they have jobs that match their skills.
But, like any policy, there are trade-offs. Tightening monetary policy to reduce inflation, for example, will also likely cut economic growth and put upward pressure on unemployment, all else being equal. So, central banks have to balance these objectives.
One challenge is keeping abreast of new financial instruments that may threaten financial stability. Some of these innovations are designed to lower transactions costs and increase leverage. Others can obscure risk or allow financial firms to conceal it. The subprime mortgage crisis demonstrates these dangers.
Another challenge is ensuring that the central bank is not influenced by political forces. A major concern is that if voters were to choose a political wave, a central bank’s board could be aligned with that group’s desires for low or high inflation, for example.
The fact that a large percentage of the directors of Reserve Banks are appointed by Fed member banks—in a situation described, at best, as inherently conflicted and, at worst, as regulatory capture—exacerbates this problem. This degree of independence from the rest of government makes it difficult to hold a central bank accountable for its performance.