Central bank policy affects borrowing, spending, investing, business activity, hiring, and economic growth. It can also influence the rate of inflation. Policy includes adjusting interest rates, buying and selling government bonds, setting foreign exchange rates, and changing the amount of cash that banks must hold as reserves.
Traditionally, changes in a central bank’s policy interest rate are supposed to flow through to other short-term market interest rates. But empirically, this has not always happened. One reason is that specific credit markets become blocked. To circumvent this, central banks set up special facilities to buy commercial paper and mortgage-backed securities. These facilities provide a massive infusion of liquidity, allowing private borrowers to borrow at lower costs. The choice of who gets this funding is politically driven. It privileges some borrowers over others. Another problem is that these facilities are not transparent, and they lack oversight by an official accountable to voters.
A related issue is the footprint of a central bank. Some argue that a central bank should minimize its footprint in financial markets, backing reserves with stable outright holdings of securities and conducting only open market operations to change the federal funds rate. This strategy may be hard to implement. To do it properly, a central bank would need to supply a buffer of extra reserves to account for uncertainty in estimates of reserve demand and absorb variability in autonomous factors that add or drain reserves. In addition, the process of supplying a large quantity of reserves through ceiling tools can crowd out healthy market intermediation and increase the risk of asset bubbles.