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Q&A: Central banks pull the strings

What is a central bank?

Think of it as the big boss bank. In simple terms, in most countries a central bank is a government agency that helps to regulate economic activity. It might set interest rates, make emergency loans and set rules for other banks.

In the United States, the Federal Reserve System is independent. It's a public-private hybrid created in 1913. It gets its authority from Congress, but funds itself with investments. The idea is to keep politics out of monetary policy by protecting it from congressional budgets. But it's still subject to oversight by Congress.

Lately it has been invoking Depression-era powers — plus some new ones granted by Congress in the bailout package — to shore up a shaky financial system. That includes buying up banks' toxic investments, loaning out hundreds of billions of dollars and now directly purchasing some companies' short-term debt.

Meanwhile, central banks around the world have also had to dump billions of dollars into financial institutions to keep them afloat and have tried to coordinate to inspire confidence. Australia's central bank lowered interest rates by the largest amount since 1992 in a surprise move Tuesday, and that reignited hopes that others, including the Fed and European Central Bank, might follow suit.

Will our central bank cut interest rates?

If the Fed does lower its key rate from 2 percent it would mark an about-face. The Fed in June had halted aggressive rate-cutting to revive the economy out of fear those low rates would aggravate inflation.

Since then, financial and economic conditions have deteriorated, while record-high energy prices have calmed, giving the Fed more leeway to again cut rates.

Federal Reserve Chairman Ben Bernanke warned Tuesday that the financial crisis has not only darkened the country's current economic performance but also could prolong the pain. The Fed chief's more gloomy assessment appeared to open the door wider to an interest rate cut on or before Oct. 28-29, the central bank's next meeting.

What is commercial paper, and why is the Fed going to buy some?

Large corporations with good credit ratings don't need banks to borrow money. They just ask investors to loan it to them, offering written promises to pay the money back. They often borrow for short periods, from overnight to three months. It's a common way for large companies to maintain their cash flow to pay workers and buy supplies. Money market funds are typically the largest holders of commercial paper.

But lately, investors don't trust they'll get their money back — they're sticking it in safe government debt instead. So the market for commercial paper has dried up. That's why the Federal Reserve announced a plan Tuesday to buy companies' short-term debt. The Fed said it hoped that would jolt the commercial paper market back to life.

Becky Bowers can be reached at bbowers@sptimes.com or (727) 667-0509. Information from the Associated Press, Federal Reserve and World Book Encyclopedia was used in this report.

Q&A: Central banks pull the strings 10/07/08 [Last modified: Wednesday, October 8, 2008 2:38pm]
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