Volatility: How does it affect central banks?

When we talk about volatility we refer to the set of fluctuations that occur in the prices of financial assets as well as in the different economic variables.

It is a highly complex phenomenon, the result of the confluence of different factors and, also, with consequences of a different nature. Understanding the particularities that characterize and determine it becomes essential as it allows us to anticipate changes and respond more effectively to challenges. That is no different in the context of central banks, but how are they affected by volatility?

The appearance of fluctuations is determined by different types of factors and each of them has specific ramifications within the markets. Some of the most common are:

Variations in Interest Rates: The decisions made in this regard by central banks, as well as the alteration of the expectations of said rates, can have a significant impact on the financial markets in the form of volatility.

Factors of a geopolitical nature: The emergence of tensions or conflicts between regions, as well as the presence of high-profile trade confrontations, can lead to a climate of uncertainty, acting as sources of volatility.

Oscillations in raw materials markets. Variations in oil or gold prices can have a destabilizing effect, especially if we are talking about countries and regions dependent on the export of said raw materials or products derived from them.

Circumstantial events and crises: The emergence of unforeseen events such as, for example, natural disasters or economic crises can be the fuse that opens the way to new turbulence and that, ultimately, translate into volatility.

The appearance of new volatilities generates an impact on financial markets with more or less tangible consequences, such as:

Risk of potential losses to investors. With volatility, the chances of losses being recorded increase since the assets, based on it, experience considerable movements.

Opportunities and risks in the trading sector: The consequences of volatility do not necessarily have to be negative. In fact, it can mean opportunities for those professional traders who want to try to obtain some type of profitability from market movements. However, the CFD trader must keep in mind that these potential opportunities also represent a significant level of risk. Above all, when taking into account the characteristics of tools such as leverage. A good strategy based on solid knowledge and good management of the associated risk will be of vital importance.

More inaccurate valuations: Price variability implies greater complications when carrying out accurate valuations of financial assets. This can lead to new constraints on decision-making processes and funding strategies.

As we can see, financial volatility inevitably represents the assumption of challenges by central banks as they are the institutions that work to guarantee financial and monetary stability. In turn, these challenges imply the appearance of certain vulnerabilities within the financial system and can put the effectiveness of monetary policies in the spotlight.

The introduction of complexities in the formulation and application of adapted monetary policies constitutes one of the main centers of gravity. The succession of drastic fluctuations in the markets is accompanied by new peaks of uncertainty that hinder the definition and management of inflation expectations. On the other hand, the oscillation of interest rates can translate into obstacles when defining stable reference rates by the central bank.

Lastly, the limitations in terms of anticipation-reaction put in check the capabilities of the central bank to consolidate a consistent monetary policy. To this we must also add that the volatility of exchange rates can lead to a loss of competitiveness of the currency in international markets, which can add additional problems to inflation control procedures.

The proliferation of volatility can trigger uncertainty in the markets and, in the worst case, a fever of panic. When these types of situations occur, massive withdrawals of deposits can occur, which can lead to further intensifying instability.

Furthermore, there is an added and implicit risk in the interconnection that exists between financial institutions and markets. When an impact occurs in one segment of the financial system, a propagation can occur that spreads the consequences to other segments with a domino effect. In this sense, it is essential that central banks are alert to the imminent possibility of a systemic crisis occurring and must have the resources to intervene and guarantee financial stability.

On the other hand, volatility in asset markets can lead to a significant swing in the value of banks’ assets, which also has consequences for their balance sheets and soundness. In this type of context, the implementation of complementary regulatory and supervisory measures is essential to guarantee the sustainability of the banking sector.