Fundamental Analysis – What Monetary Policy is, and How to Interpret It

Monetary policy is the sum of all decisions taken by a central bank. The monetary policy is not just hiking or cutting the rates, but all the things that a central bank does: communication, implementation, and forward guidance. We covered the forward guidance principle here in a different article, and also what a central bank’s role is. There is, however, still a need to explain in more detail what monetary policy is, and why Forex trading depends on what central banks are doing.

Defining Monetary Policy

Central banks are independent organisations that monitor the economy and set the interest rate for their specific currency. The interest rate does not change at every central bank meeting, and neither does the monetary policy. When it comes to interest rates, a central bank has three options: to keep the rates steady (no hike and no cut); to cut them; or to hike them. The currency moves aggressively when the interest rate is changed: If the interest rate is raised, the currency will appreciate, and if the interest rate is cut, the currency will depreciate. It is only normal for this to happen, as everyone wants to own a currency that pays a higher interest rate, or to dump the currency when the rate is falling. When the economy is growing, the central bank raises the interest rates. This change in the interest rate can be part of a tightening cycle, or can be just to curb inflation. On the other hand, when the central bank cuts the interest rates, this can be the start of a so-called easing cycle, or just part of adjusting the rates. Nevertheless, any changes are all part of the monetary policy.

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Hiking and Cutting the Rates

To the surprise of many, it is not mandatory for a central bank  to hike or cut the rates, or to move on rates after every meeting. The decisions made at a central bank’s meeting need time to implement, and even more time for their effects to be seen. In view of this the central bank will, most of the time, engage in communicating to market participants their intentions regarding rates and the economy overall. The perfect example comes from the Bank of England. After the 2008 financial crisis, the Bank of England didn’t change its rates for many years to follow, even though the Monetary Policy Committee (MPC) meets monthly. The committee simply assessed the economy for each previous month, and communicated the future monetary policy stance without acting on rates.

Unconventional Measures

monetary policy reportCentral banking is a tough business, as the monetary policy needs to reflect and address the problems an economy faces. There is no straight road when it comes to monetary policy, and standard measures do not always work. As mentioned earlier, raising or hiking rates comes in response to inflation rising or falling. But what is to be done when inflation keeps falling when the interest rate is already at the zero level and threatens to fall even further? When inflation falls below the zero level, it is said that deflation is gripping the economy. Fighting deflation is a totally different thing from fighting inflation; in fact, it is even more difficult to fight deflation than inflation. To fully understand this, deflation forms when consumers stop spending. When this happens, a vicious circle starts: No spending means the stores are not selling their products anymore. This, in turn, leads to inventories building up, and the stores stop ordering more goods. In response, factories do not produce as much, and they  have to lay off people. This, in turn, will result in more people applying for unemployment benefit, which will be a problem for the government.

To fight deflation, unconventional measures are applied. All major central banks in the world, in the last few years, have embarked in QE (Quantitative Easing) programmes. Under such programmes, the central banks buy their own government bonds, among other things. The main idea is to cause inflation, as this should be the result of an expanding economy. However, this is a dangerous thing to do, as history shows us that artificially created inflation almost always spirals out of control. All central banks in major economies, starting with the Federal Reserve in the United States and the Bank of Japan, and ending with the European Central Bank and the Bank of England, engaged in various quantitative easing programmes. While the Fed has ended its programme and has now entered a tightening cycle, the European Central Bank is still running an aggressive QE programme destined to stimulate the Eurozone economies. The same is valid in Japan, where the Bank of Japan is still buying all the Japanese Government bonds it can get its hands on. Other unconventional measures are moving rates into negative territory (European Central Bank, the Swiss National Bank, and other Nordic countries in Europe are following the same policy); Targeted Long-Term Refinancing Operations (TLTROs), and Troubled Assets Relief Programmes (TARPs), etc. The idea is that a central bank will stop at nothing to bring inflation back on track, and with it to get the economy growing. Inflation is part of a central bank’s mandate, and dealing with it is its main task.

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