Central banks have tremendous influence over financial markets. To understand this, we need to understand not only what central banks are, but also their designated role in the economy. 
What do central banks do?
Central banks are national organisations in charge of conducting monetary policy (the regulation of interest rates and the money in circulation), such as the Bank of England, the European Central Bank, and the US Federal Reserve. As theoretically independent bodies, they are also responsible for regulating the nation’s banking system and providing other financial services.
The common goal of all central banks is to foster economic stability within their own region. As part of this aim, most central banks aim to keep domestic inflation at low but positive levels – usually around 2 per cent over the medium term. This should keep consumer prices under control while also encouraging gently rising wages (themselves usually a sign of a high employment levels). However, some central banks have other specific mandates too. For example, the US Federal Reserve has a dual mandate of 2 per cent inflation alongside low unemployment, as part of wider curator’s role within the economy.
How do central banks impact the economy?
Central banks impact the economy when they take action to control levels of liquidity (in effect, the total amount of money) in the financial system.
In doing so, they have a number of levers to pull. The most publicly visible is the setting of interest rates, providing a guide for other financial institutions’ rates when issuing loans, mortgages and bonds. If inflation looks too high, the central bank can raise interest rates, slowing spending and growth rates; if inflation looks too low, the central bank can lower interest rates to incentivise spending and stimulate the economy.
What influence do they have over investment markets?
In the wake of the financial crisis in 2008, central banks worked hard to boost the beleaguered global economy. This meant slashing interest rates (in some cases to negative levels and record lows) in an attempt to bring down the cost of capital in the global economy, making it cheap to borrow and spend, and aiming to give a shot in the arm to production and employment.
Central banks also pulled a second lever, embarking on massive asset purchase programmes known as quantitative easing (QE). This involved buying large amounts of ‘safe haven’ assets like government (and later corporate) bonds, lowering the yields on these assets and pushing investors into more adventurous areas of the market in search of returns. Some of these quantitative easing schemes have simply been replaced by new ones upon expiry, as in Europe, leading to a ballooning total amount of assets held by central banks since the financial crisis. At the end of 2000 (some years before the crisis), the largest three central banks in the world combined owned around $1.3trn of publicly-traded assets. Today, this figure is closer to $13trn.
How has this altered the investment landscape?
Since the financial crisis, central banks have become one of the largest institutional holders of public market assets. This means that they have more capacity to impact market prices than ever before, leaving other investors somewhat at the mercy of their policies.
Interest rate cuts across the developed world have also led to an unprecedented spate of negative-yielding debt, with global levels skyrocketing from $6trn in October 2018 to peak at a record-breaking $17trn over the summer. Given that this means lenders (i.e. bond market investors) are effectively paying borrowers (governments and businesses) for the privilege of giving out their capital, if these bonds are held to maturity, this is a truly staggering place in which to find ourselves.
There is also some evidence to suggest that central bank activity over the past decade has led to unintended societal consequences: post-2008 policies may have disproportionately benefited the wealthy, in turn fuelling a rise in populist voting patterns. This has led to extremist political agendas finding their way into mainstream economic discourse, including a growing wave of protectionist policies on the right, as well as drives for (re)nationalisation of private assets on the left.
Can central banks maintain their power?
Central bank policymakers (particularly in Europe) are increasingly calling on governments to enter the fray and begin spending to aid economic growth. If this materialises in earnest – particularly from economic powerhouses like China and Germany – it would almost certainly mean a boost for investment market sentiment.
In the meantime, global growth is slowing, and with already record-low interest rates, central banks have limited traditional weaponry left in their arsenals. Their potential to adapt should not be underestimated, and governments may yet step up. However, given the sheer volume of assets purchased in recent years, investment markets are understandably questioning just how much firepower the central banks have left in this already very long period of economic expansion, and how effective they can be in tackling the next crisis. Only time will tell.
David Absolon is investment director at Heartwood Investment Management. The views expressed above are his own and should not be taken as investment advice.