Central bank policy is the set of rules that governs how a central bank manages the economy. It includes the interest rate target, which is typically reviewed on a monthly basis by a policy committee and is used to keep the market on track to achieve a defined inflation target. It also includes monetary stability goals, which aim to limit asset price booms and prevent financial instability.
The primary goal of central banks is to provide price stability (currently viewed as low inflation over the long-run). This requires credibility, and it is greatly enhanced by effective policy communication. For this reason, the best way to communicate a policy is through an explicit inflation target. This creates a feedback loop between effective policy actions, well-anchored expectations, and price stability. This short-circuits so-called second-round effects, which can exacerbate and prolong shocks to the economy.
In the event of a financial crisis, central banks should be ready to act rapidly to ensure the financial system remains stable and avoid widespread damage. This involves providing liquidity to the money markets and ensuring that financial institutions can continue to finance businesses and households. To do this, a central bank may open a discount window and accept whatever sound collateral is offered, or buy assets such as commercial paper and mortgage-backed securities. In addition, many central banks have implemented leverage ratio requirements for financial firms, or minimum capital standards, which act as a form of regulatory backstop to mitigate risk and limit the amount of leverage in the financial system.