Monetary Policy and its Effects on the Value of Currencies

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Monetary policy decisions are some of the highest impact events as it relates to exchange rate price movements. It’s imperative that traders and investors understand how central banks operate and the tools that they have at their disposal to effectively manage economic growth while balancing the negative effects of inflation. We’ll examine these topics and present some additional considerations that are applicable to foreign exchange traders.

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Definition of Monetary Policy

Central banks seek to create a healthy economic environment for its citizenry. They are tasked with taking specific actions to control the overall money supply within their country or region. Each central bank will have its own mandate for promoting economic growth while balancing the effects of inflation. There are various forms of money supply including cash, checks, and credit. A primary source of money supply is credit, which can come in the form of bonds, mortgages, loans, or other types of security interest.

Many central banks give authority to a board for planning and implementing the actions undertaken in this effort.  In short, monetary policy makers are responsible for managing the supply of money, deciding on interest rate matters, and maintaining an acceptable level of inflation.

The central bank has various tools within its arsenal to achieve the goals that are aligned with their mandate. This can include initiating changes to the interest rate, revising reserve requirements for banks, and engaging in quantitative easing or tightening activities, to name just a few. The decisions made by the central banks can have regional as well as global implications. As such, most financial analysts, and economists keep a keen eye on interest rate decisions and other policy statements made by members of a central bank’s governing board.

The monetary policymakers themselves arrive at their decisions based on various economic metrics. This includes data on employment, inflation, GDP, trade figures, and much more.

One of the most powerful central banks in the world is the Federal Reserve Bank of the United States. The Fed is said to have a dual mandate. Specifically, their aim is to create the highest level of employment, while maintaining a reasonable rate of inflation. Within the federal reserve, it is the Federal Open Market Committee (FOMC) that is responsible for monetary policy decisions.

Types of Monetary Policy

As we now know, one of the primary functions of central banks is to implement a monetary policy. But what are the key monetary policy types? The two types of monetary policies include an expansionary monetary policy, and a contractionary monetary policy. Let’s discuss each in more detail.

Expansionary Monetary Policy – When a central bank takes an expansionary policy, it is taking steps to increase the money supply. A few of the ways that this can be done include reducing reserve requirements for banks, lowering of interest rates, and purchasing of security instruments. This increases the money supply and helps boost the overall consumer spending and business activity within the economy.

As a result, it will have the effect of increasing the level of employment within the economy as well. The ultimate goal of an expansionary monetary policy is to increase and stimulate economic growth. The one downside that needs to be balanced by monetary policymakers is a rising rate of inflation during such an undertaking.

One example of an expansionary policy is to cut the interest rates down as much as possible, even as low as 0% in some cases. This tends to have a positive effect on consumer and business spending. It opens up the credit markets that in turn help fuel the economy as a whole. Another example of expansionary monetary policy that has been used quite often in recent times is the implementation of quantitative easing, also referred to as QE. Quantitative easing refers to major asset purchasing activities, typically of securitized bond instruments, undertaken by a central bank.

Contractionary Monetary Policy – The flip side of an expansionary monetary approach is a contractionary policy as it relates to the money supply. More specifically, a tight money policy measure has the effect of reducing the quantity of money that flows through the economy.

This would include specific actions taken by the central bank such as increasing the rate of interest, raising the reserve requirements of banks, and the selling of securitized bond instruments in the open market. Typically, when the economy becomes overheated, and there is a fear of hyperinflation, the central bank may step in to curve the level of consumer and business activity in the economy.

There is always a fine line between economic growth and the rate of inflation that monetary policymakers are seeking to balance. Contractionary policy measures are also sometimes referred to as a restrictive monetary policy. These terms are interchangeable. In any case, it’s important to understand that contractionary measures can help combat high inflation. But, sometimes that can come at a cost if it is not managed properly. That is to say that an extended period of contractionary policies can lead to a mild or full-blown recession.

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Tools of Monetary Policy Makers

There are a variety of ways that a central bank can implement its monetary policies. Let’s take a look at three major tools employed by monetary decision-makers.

Money Supply and Interest rates – One of the primary tools that monetary policymakers rely on to meet their objectives is through setting and adjusting lending interest rates. For example, the FOMC sets the fed funds rate, which is essentially the rate at which banks can borrow from other banks to meet preset cash reserve requirements.

This rate then becomes the basis for other types of credit related activities within the economy. Obviously, when the central bank’s lending rates are set at higher levels, the overall consumer and business borrowing activities will dampen, while a reduced rate of interest will spur economic activities as the borrowing costs become much more attractive to businesses and consumers.

Open Market Operations – When a central bank transacts in the market for the purpose of buying or selling security products, that activity is referred to as open market operations. Essentially, when the central bank purchases assets, it is adding cash into the banking system. This in turn enables commercial banks to lend out more money to its client base.

And the reverse occurs when the central bank sells off securities it is holding. In that event those assets are transferred onto the balance sheets of the major banks, which in turn lowers the cash position for these banks. In short, this creates a situation wherein the bank has less funds available for lending to its credit worthy clients.

Quantitative easing has been a recent phenomenon that has swept across many different regions. It refers to open market operations that are done at a large scale. An example of quantitative easing occurred following the great financial recession of 2008, when the Federal Reserve dramatically increased its purchase of securitized assets, including but not limited to mortgage-backed security instruments.

Bank Reserve Requirements – Major central banks around the world require a certain capital threshold to be maintained as a reserve. In other words, private commercial banks that bring in deposits from its client base must allocate a preset percentage of those funds to serve as a reserve. This helps ensure that depositors funds are being safely managed, and that there is sufficient money available to meet current and ongoing liabilities as and when they come due.

When the central bank lowers this reserve requirement, it frees up more resources for the banks, which in turn can be utilized for lending purposes. This has the effect of stimulating the economy as banks become more aggressive in their lending standards. On the other hand, increasing the reserve requirements has the opposite effect. That is to say that as the reserve requirement is increased, it will result in less bank loans being offered to clients. And this in turn will have the effect of slowing down or curtailing economic expansion.

Exchange Rates And Monetary Policyexchange-rate-monetary-policy

You should now have a basic understanding of monetary policy, and the role of central banks and its policymakers. Additionally, we have learned a few of the primary means by which monetary authorities can implement their policies. Now let’s shift gears a bit and discuss how monetary policy effects the currency markets, and particularly exchange rates.

Central banks of different nations have different policies and mandates as it relates to managing their currency. The US dollar, for example, is a freely floating currency. This is to say that the exchange rate policy of the the Federal Reserve is to not directly engage in the management of the value of the Dollar. Rather, it sets specific policies and measures to achieve its dual mandate. Countries such as China, on the other hand, actively manage their currency exchange rate.

So what happens when a central bank such as the Federal Reserve decides to raise its interest rates. Well, we know from our earlier discussion that this will have the effect of curtailing growth within the US economy. But, what happens at the more global macro level? Well, let’s think about that for a moment.

When the Fed increases its interest rate, that often creates additional demand for the US dollar internationally. Why? Well now investors outside of the United States can enjoy an increased return on their dollar denominated holdings since from their perspective a higher interest rate equates to a higher return on their capital.

As a result, rising interest rates can have the effect of increasing additional demand for a currency, which in turn will cause its exchange-rate to rise as well against other currencies.

The flip side of this is when the Fed decides to reduce the current interest rate. When this occurs, we know that from the perspective of the US economy, that it will typically have the fact of spurring economic growth. But, from the perspective of the international investor, this reduced interest rate, will be viewed in a different light. That is to say that the international investor seeking higher yields in a global market may find an investment in US denominated assets less attractive now due to a lower rate of return.

These are somewhat overly simplistic examples, however, the logic behind it remains sound. Inevitably, in a global marketplace, there will be many other factors that can contribute to exchange-rate price movements that go beyond these considerations. Some other factors that should also be evaluated when trying to assess the potential impacts of monetary policies on exchange-rate pricing include trade balance, future economic prospect, commodity demand and correlation, to name just a few.

Interest Rates Basics For The Forex Trader

As you should be aware by now, one of the biggest drivers of foreign-exchange rates is the interest rates set by central banks. As such, Forex traders need to be cognizant of scheduled meetings and announcements of major central banks around the world. The decisions that central bankers make can influence the price of a currency pair both in the short term and over the longer term time horizon as well.

Many major currency pairs will become extremely volatile immediately following an interest rate decision. This is especially true if the central bank acts contrary to what was unexpected by major economists and analysts. The price of a currency pair can spike up or down hundreds of pips in an instant when such an event occurs.

And the ramifications of an interest rate policy, be it a rate hike or rate cut, can be felt for weeks and months, as investors around the world digest the new information. Money will often flow out of currencies that offer lower yield, and flow into currencies that offer higher yield. One popular strategy that many large hedge funds and institutions utilize in the foreign exchange market is the carry trade.

The carry trade seeks to purchase a currency with a high yield, and simultaneously sell a currency with a lower yield. The lower yielding currency is said to finance the higher-yielding currency. For example, the Australian dollar to Japanese Yen is a popular currency pair for carry traders. This is because as of now, the interest rate for Australian dollar is much higher than that of the Japanese yen.

As a result, the net interest earned on the disparity between the interest rate of Australian dollar and the Japanese Yen can result in a potentially profitable trade. And the profitability of the position can the amplified with the use of leverage.

However, the carry trade is not without risks. The obvious risk is that the Australian dollar depreciates in value against the Japanese Yen above and beyond the interest rate differential. When this happens, the carry trader’s position will be in the red as a result of the adverse price movement in the exchange rate. There are many different strategies that Forex traders can employ around interest rates. The carry trade is just one such interest rate based trading strategy. Nevertheless, it is one of the more popular ones.

Another method that Forex traders can implement is to try to predict future central bank policy decisions. Fundamental analysts study the underlying economic conditions for a specific country or region in an effort to gauge what monetary policymakers are likely to do in the future.

This can prove to be a very challenging proposition because of the large number of moving parts that need to be carefully studied and analyzed.

Even then, one can never fully know how central bankers are likely to react to different economic conditions. In any event, being on the right side of a major central bank decision, and positioning accordingly in the market, can certainly pay high dividends for one’s effort.

Download the short printable PDF version summarizing the key points of this lesson….Click Here to Download

Final thoughts

The impact of monetary policy and exchange rate fluctuations should be studied closely.  Although the foreign exchange markets take into account many factors outside of central bank decisions, they are nevertheless, one of the primary drivers of exchange-rate movements both at the micro and macro levels. As such, traders should be aware of the different types of stances that can be taken by central-bank authorities and the effects of an expansionary vs contractionary monetary policy.

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