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Central Banks And Monetary Policy

The policy decisions taken by central banks and governments have a huge impact on the price of a currency or pair. We’ll explain how monetary policy works, who the biggest influencers are, and why you need to sort the hawks from the doves.
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    Changing monetary policy

    Understanding how markets expect central banks to change monetary policy (interest rates) is vital to understanding how markets price financial assets.

    • “Is the Federal Reserve going to raise interest rates?”
    • “Is more Quantitative Easing possible?”
    • “When will they make their move?”
    • “How high could rates go?”

    What you need to consider

    These are questions that traders and investors need to consider. In forex terms, monetary policy is probably the most important area of macroeconomic data.

    There are two main ways that a country can manage its economy:

    1. Through Fiscal Policy (i.e. taxation and government spending)
    2. Through Monetary Policy (i.e. when a central bank alters the level of interest rates).

    Although fiscal policy can have an impact on the economy, it’s when changes occur to monetary policy that markets really sit up and take notice.

    What is Monetary Policy?

    Traditionally, a central bank (such as the US Federal Reserve or the European Central Bank) can either raise or lower its INTEREST RATES.

    Following the 2008 Financial Crisis, interest rates were broadly cut towards zero (ZIRP – Zero Interest Rate Policy) resulting in the need for unconventional monetary policy measures. Central banks subsequently introduced QUANTITATIVE EASING – using electronically created money to purchase bonds (usually sovereign debt). This is monetary policy designed to increase private sector spending and help generate inflation.

    INFOBOX: Tight vs Lose monetary policy

    Broadly, a central bank has three options with regards to monetary policy. It can choose to:

    • LOOSENLOWERING (or cutting) interest rates. In recent years this has involved engaging in or increasing the Quantitative Easing of asset purchases.
    • TIGHTENINCREASING (or in central bank parlance, “hiking”) interest rates. This can also be the unwinding of QE or Quantitative ‘Tightening’. Central banks sell back bonds previously purchased under QE programmes as they try to unwind their large balance sheets.
    • NO CHANGE – Or in other words “stand pat”, where a central bank does not change monetary policy.

    A change in monetary policy can have a profound impact on the following:

    Hot money flows – a difference in the interest rate will lead to inflows (on higher rates) or outflows (on lower rates) to the domestic currency. This is because international traders are looking to benefit from the interest rate differentials between the two countries. An increase in interest rates is typically beneficial for the domestic currency because of demand for the currency increases. 

    Bond markets – because bonds are a fixed-income asset class, changes to the interest rate change the relative attractiveness of domestic bonds. An increase in interest rates will drive demand for bonds down due to the change in the opportunity cost of holding cash over that of holding bonds. If you get more interest-holding cash, then there will be a shift in the demand for cash over bonds – and, therefore, the price of bonds will fall (note: this will push the yield on bonds higher due to the inverse relationship between the price of a bond and the yield).

    Why is Monetary Policy so important?

    Central banks consider all of a country’s economic indicators when deciding how to configure the monetary policy. Some, however, are clearly more important than others. Inflation, unemployment, and GDP growth all feed into the overall economic outlook and, subsequently, into how central banks view where the economy is moving. 

    If an economy is heating up, then the economic indicators will start to improve. This will generally mean that growth will increase, unemployment will fall, and inflation will start to rise. 

    Goldilocks and the Three Bears can provide a good analogy for the balance central banks try to achieve in these circumstances. In short, central bankers don’t want the economy to run too hot or too cold, and they want the economy to be just right. 

    They want the economy to improve but not overheat. That is why central bankers will look to increase interest rates in order to take the steam out of an economy and stop inflation from running out of control. 

    Observe the composition of key monetary policy committees

    • The composition of monetary policy committees will impact the market outlook for monetary policy. Changes to voting rights (especially on the US Federal Open Market Committee or FOMC) from year-to-year are watched closely by the market. 
    • Speeches from central bankers that take place outside the normal schedule of central bank announcements can provide a gauge of current views of the voting membership on monetary policy committees.
    • Also – watch for any shifts of individual opinions/positions (especially from voting members) which could impact on future monetary policy decisions.

    Take away: The impact of monetary policy

    Changing interest rates will impact across a whole range of asset classes. All things remaining equal, an increase in interest rates should:

    • Strengthen the domestic currency
    • Weaken domestic bond prices and therefore strengthen bond yields 
    • Potentially weaken domestic equities *

    *N.B. this is not entirely certain. Equities tend to perform better in looser monetary policy environments, but an increase in rate could be due to the drive to normalise interest rates (after a period of ultra-low rates). This can also be seen as a sign of confidence in the economic environment that companies operate in, and be a signal of better future prospects.

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