How Does Monetary Policy Affect the Forex Market?

Governments, and the central banks that operate within the countries, set monetary policy that is designed to help bolster the economy of that country.

Central banks and monetary policy are two concepts that always go together. The reality is that you cannot have one without the other. In fact, the only real mandate of a central bank is to create a monetary policy that helps the country meet its specific economic goals and targets.

At the end of the day, monetary policy is designed to encourage stability and growth in the country where those policies are put in place. There are various things that central banks do to get a grip on monetary policy.

A few of the things that they have some control over include:

• The interest rates for borrowing money
• The money supply
• The rate of inflation in the country
• Lending reserves to commercial banks
• Interest on reserve balances held by the commercial banks

Types of Monetary Policy

There are different types of monetary policy that one needs to take into account when they are reviewing what a central bank does. After all, there are various steps that may be taken by a central bank to try to control what is happening to the money supply and other factors within the borders of that country.

Restrictive monetary policy is what a central bank may issue when it is attempting to reduce the size of the money supply that is available within a given country. It may do so by raising interest rates.

The purpose of this is to slow economic growth by causing the cost of borrowing to rise. This may be necessary during periods of high inflation.

Expansionary monetary policy is the opposite of restrictive policies. The purpose of expansionary monetary policies is to allow the economy to run wild.

Decreasing interest rates charged on borrowed money makes it easier for more people to borrow the money that they require. This may make it easier to borrow in general, and that prompts more people to take out loans and spend money. As they do so, the economy expands.

A neutral monetary policy is set when the goal is not to restrict or expand the availability of borrowing.

Neutral monetary policies are best implemented when the economy and inflation seem to be both flowing in the right direction and at the right pace.

Some inflation is generally seen as a good thing because it means that people are spending some of their money. That is important to the continued growth of the economy as a whole.

The general consensus is that there should be a happy medium between the amount of inflation that occurs in an economy and the amount of economic growth that can be sustained within that same economy.

Central banks prefer when they are able to establish this type of stability for the economies that they serve, and traders also prefer to have a stable market as well. It is the only way that they can effectively trade without the spectre of too much volatility getting in their way.

Monetary Policy Runs in Cycles

The fact remains that central banks will only move interest rates in such a way as is deemed necessary to spur economic growth or fight inflation.

The changes that are made are generally very gradual and deliberate. This is because the central banks know that it would throw everything into a state of chaos if they were to push too hard or too fast on interest rate changes. As such, it is often the case that the changes made are highly incremental and will move only as market conditions warrant.

Typically, rate changes of 0.25% to 1% are the norm. Stability comes from the fact that the rate changes take many months or even many years to be fully implemented into the system. Thus, you shouldn’t expect any sudden or dramatic bump to take place without at least a little warning ahead of time.

The lag time that is experienced between when the interest rate change is announced and when the effects of it are felt in the economy can be up to 2 years in length. Thus, this needs to be considered when thinking about how to trade the various currencies that you are looking at.

You don’t necessarily need to anticipate that there will be an immediate economic impact from rate changes. You simply need to keep an eye out for what could potentially happen as a result of the moves made by any central bank out there.

 Pop Quiz

Based on these brief comments by Jerome Powell, the United States Federal Reserve Chair, is the Fed pursuing policies that promote expansion, contraction, or neutrality?