Monetary Policy refers to the policy used by central banks to manage the supply of money or trading in the foreign exchange market.
Central banks typically have two core mandates:
– Preserve the stability of prices/contain inflation
– Foster an environment for sustainable economic growth
Expansionary Monetary Policy
Expansionary monetary policy increases the total supply of money in the economy. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates. The reduced cost of borrowing aims to increase consumer spending. An expansionary monetary policy is used when economic growth is low and unemployment is rising.
A dove is a central banker who will a monetary policy fostering growth and is generally reluctant to tighten rates.
Contractionary/Rrestrictive Monetary Policy
Contractionary Monetary Policy decreases the total money supply. Contractionary policy has the goal of raising interest rates to combat inflation. Central banks employ a restrictive monetary policy when the economy is seen to be expanding too fast. Increased demand with the lower cost of borrowing may lead to dangerous levels of inflation.
A hawk is a central banker who takes an aggressive stance on fighting inflation and is open to raising interest rates even if it will slow economic growth.
The foremost mechanism of adjusting monetary policy is the adjustment of benchmark interest rate. In the US this is the Federal Funds Rate.
The benchmark rate set by central banks determine the cost of borrowing between banks. This is then reflected in the interest rates the banks charge firms and individuals to borrow money.
Central Bank also use:
Changes in money supply – the overall amount of money in circulation. The Fed can influence the money supply by modifying reserve requirements, which is the amount of funds banks must hold against deposits in bank accounts. By lowering the reserve requirements, banks are able loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks’ reserve requirements, the Fed is able to decrease the size of the money supply.
Reserve requirements – the amount of capital set aside by the banking system that cannot be used for lending.
The Fed can alter the money supply by conducting open market operations, which affects the federal funds rate. In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply. Conversely, if the Fed wants to decrease the money supply, it sells bonds from its account, thus taking in cash and removing money from the economic system.
Monetary Policy Cycles
Changes in monetary policy typically involves many small adjustments to interest rates. Normally interest rate changes made by central banks are in .25% increments (25 basis points) or .50 (50 basis points)
50 basis points were used in extreme situations such as the Asian Financial Crisis of 1998.
There is a time lag between when interest rates are adjusted and when they affect consumer behavior. The Fed itself estimates that monetary policy changes carry a 12-18 month time lag – rate changes made now may only affect the economy a year from now.
Tolerable levels of inflation are cited as being about 2 to 3% annually.
In the late 1970’s and early 1980’s Fed Chairman Paul Volcker was committed to defeating inflation paving the way for Alan Greenspans Fed policy.
Volcker’s Fed is widely credited with ending the United States’ stagflation crisis of the 1970s by limiting the growth of the money supply, abandoning the previous policy of targeting interest rates. Inflation, which peaked at 13.5% in 1981, was successfully lowered to 3.2% by 1983. The change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression.
Significance of Monetary Policy to Currency Traders
Information given out by Central Banks can cause market reactions in the same way as significant economic releases.
Interest Rate Decisions. Interes rate setting committees of central banks convene at regularly scheduled meetings. At the end of the meeting they will issue a formal announcement of the policy decisions made – raising, lowering or maintaining interest rates. Here they can also make changes to reserve requirements and liquidity operations.
Policy Statements. Central banks frequently issue a statement to accompany the interest rate decision that explains the basis of their decision and may provide guidance on future monetary policy direction.
Public Speeches. Central bankers often make public speeches to community and business groups and while discussing the economic outlook they may give away clues to their monetary policy plans.
How to Interpret Monetary Policy Statements
The interest rate setting committees of central banks – such as the Fed’s FOMC – normally operate under one vote per member.
A scheduled speech by the chair of the Fed can trigger a sharp reaction in the markets.
The FOMC is composed of 12 voting members – made up of the board of governors and a rotating number of Federal Reserve Bank presidents each year. Bear in mind that a Federal Reserve Bank president is not necessarily a voting member when making descisions based on comments from a speech.
The strongest market reactions will come from a change in perception – when a hawkish central banker suggests that inflationary pressures are dwindling – or a dovish central banker cites inflationary risk.
Short Term Vs. Long Term Rates
Central Banks can influence short term benchmark rates through their monetary policy. However, longer term rates are set by the market. The two interes rates may diverge – the fed may try to raise the cost of borrowing, reflected in the short term rate – but if the market is awash with money the market may push longer term rates lower. In such as scenario the objectives of the central bank are undermined by the market.
Government Currency Policy
Governments are reluctant to try to influence the vlaue of their currency for a number of reasons. The forex market is much larger than any one country’s reserves.
Central Bank Intervention
Central Bank Intervention refers to central banks buying or selling currencies in the open market to drive currency rates in a desired direction.
Direct intervention in the market is an extreme measure.
Open market intervention is usually preceeded by subtler methods such as verbal intervention, where finance or central bank ministers suggest that current market environment is undesirable.
For example if the Japanese Ministry of Finance (MOF) wants to contain Yen strength in order to protect it’s exports – senior MOF officials may make a statement about the undesirable nature of exchange rate movement.
There are several different forms of central bank intervention:
– Unilateral Intervention – intervention by a single central bank to buy or sell it’s own currency.
– Joint Intervention – When two central banks jointly intervene to move the direction of their shared currency pair.
– Concerted Intervention – when multiple banks intervene together. Concerted intervention will likely result in significant changes in the market.
See also: fiscal policy (attempts to influence the direction of the economy through changes in government spending or taxes)