How Monetary Policy Affects the Forex Market

National governments and their central banking agencies, as previously stated, establish monetary policy to meet certain economic mandates or aims.

Central banks and monetary policy are inextricably linked, so you can't discuss one without discussing the other.

While some of these mandates and aims are quite similar across central banks around the world, each has its own set of goals dictated by their respective economies.

In the end, the goal of monetary policy is to promote and sustain price stability and economic growth.

Central banks use monetary policy to regulate the following in order to achieve their objectives:

• the interest rates tied to the cost of money,

• the rise in inflation,

• the money supply,

• Bank reserve requirements (the percentage of depositor balances that commercial banks must have on hand as cash)

• commercial banks' lending (via the discount window)

Types of Monetary Policy

There are a few different ways to refer to monetary policy.

If the money supply is reduced, this is referred to as contractionary or restrictive monetary policy. It can also happen when interest rates are raised.

With high interest rates, the goal is to limit economic development. Borrowing money becomes more difficult and expensive, reducing consumer and business spending and investment.

Monetary expansion, on the other hand, raises or grows the money supply while simultaneously lowering the interest rate.

The cost of borrowing money falls in the anticipation of more expenditure and investment.

Tight monetary policy aims to reduce inflation or restrain economic growth by raising interest rates, whereas accommodating monetary policy aims to create economic growth by lowering interest rates.

Finally, a neutral monetary policy seeks to achieve neither growth nor inflation control.

The most crucial thing to understand regarding inflation is that most central banks have a target in mind, such as 2%.

Their monetary policies all function and focus on attaining this comfort zone, even if they don't state it explicitly.

They understand that some inflation is beneficial, but out-of-control inflation may erode people's trust in their economy, jobs, and, eventually, their money.

Central banks enable market players better understand how they (the central bankers) will cope with the present economic backdrop by setting target inflation levels.

Let's look at an illustration.

In January 2010, inflation in the United Kingdom jumped from 2.9 percent to 3.5 percent in only one month. The new 3.5 percent rate was significantly over the Bank of England's comfort zone, with a target inflation rate of 2%.

The BOE's then-governor, Mervyn King, responded to the news by assuring the public that the abrupt increase was due to transitory circumstances, and that the current inflation rate will reduce in the short term with minimum intervention from the BOE.

The key isn't whether or not his claims were shown to be correct.

We just want to demonstrate that the market is better off when it understands why the central bank acts or does not act in respect to its target interest rate.

Simply simply, traders like consistency.

Central banks enjoy a sense of security.

Bruce Banner is a fan of consistency.

Stability is important to economies. Understanding the existence of inflation objectives will aid a trader's understanding of why a central bank does what it does.

Round and Round with Monetary Policy Cycles

Remember a few years ago when the Fed boosted interest rates by 10% out of nowhere for those of you who follow the US currency and economy (which should be everyone! )？

It was the weirdest thing to ever come out of the Fed, and it sent the financial world into a frenzy!

What, you have no recollection of this happening？

The news was all over the place.

Petroleum prices skyrocketed, and milk became as valuable as gold.

You must've been dozing off!

Oh, no, we were just playing a joke on you!

We were only checking to see whether you were still awake. That kind of drastic adjustment in monetary policy would never happen.

Because the bigwigs at the central banks would have absolute anarchy on their hands if interest rates moved dramatically, most policy changes are undertaken in gradual, incremental steps.

Even the thought of anything like that happening would wreak havoc on not only the individual trader but the whole economy.

That's why interest rates often fluctuate by.25 percent to 1% at a time. Keep in mind that central banks are looking for price stability, not shock and awe.

Part of the reason for this stability is the length of time it takes to adjust interest rates. It might take anywhere from a few months to several years.

Central bankers, like forex traders, collect and analyse data in order to make their next move, but they must consider the entire economy rather than just one transaction when making decisions.

Interest rate hikes are akin to slamming on the brakes, while rate cuts are akin to stepping on the gas, but keep in mind that consumers and businesses react more slowly to these changes.

The time it takes for a change in monetary policy to have an impact on the economy can range from one to two years.

What kind of monetary policy do you think she's following？ Contractionary？ Expansionary？ Neutral？