As previously stated, national governments and their respective central banking agencies devise monetary policy to meet certain economic mandates or goals.
Central banks and monetary policy are inextricably linked, so you can’t discuss one without discussing the other.
While some of the mandates and aims of the world’s central banks are relatively similar, each has its own unique set of goals resulting from their varied economies.
Finally, monetary policy is concerned with promoting and sustaining price stability and economic growth.
- To achieve their objectives, central banks primarily utilize monetary policy to control the following:
- the interest rates tied to the cost of money
- the rise in inflation
- the money supply
- reserve requirements over banks (the portion of depositors’ balances that commercial banks must have on hand for withdrawals)
- lending reserves to commercial banks (via the discount window)
- interest on reserve balances that commercial banks hold (IORB rate)
Types of Monetary Policy
Monetary policy can be referred to in a variety of ways.
Contractionary or restrictive monetary policy occurs when the amount of the money supply is reduced. It can also happen when interest rates rise.
With high interest rates, the goal is to limit economic growth. Borrowing money becomes more difficult and expensive, reducing consumer and business expenditure and investment.
Expansionary monetary policy, on the other hand, increases or expands the money supply or lowers interest rates.
Borrowing costs fall in the hope that expenditure and investment will rise.
By decreasing interest rates, accommodating monetary policy attempts to stimulate economic growth, whereas tight monetary policy aims to contain inflation or constrain economic growth by raising interest rates.
Finally, a neutral monetary policy seeks neither to stimulate growth nor to combat inflation.
The key point to know about inflation is that central banks typically have an inflation objective in mind, such as 2%.
They may not say it explicitly, but their monetary policies all operate and focus on achieving this comfort zone.
They understand that some inflation is beneficial, but excessive inflation can undermine people’s trust in their economy, jobs, and, eventually, their money.
Central banks help market participants understand how they (the central bankers) will deal with the current economic landscape by having target inflation levels.
Consider the following example.
In January 2010, inflation in the United Kingdom increased from 2.9% to 3.5% in a single month. The new 3.5% rate was significantly over the Bank of England’s comfort zone, with a target inflation rate of 2%.
Mervyn King, the BOE’s then-governor, responded to the report by assuring the public that the unexpected increase was due to temporary circumstances and that the present inflation rate will reduce in the near term with little intervention from the BOE.
The point here is not whether or if his claims were true.
We just want to demonstrate that the market is better off when it understands why the central bank does or does not do something in respect to its target interest rate.
Simply simply, traders prefer consistency.
Stability is important to central banks.
Stability is important to economies. Understanding why a central bank does what it does will assist a trader appreciate why inflation targets exist.
Round and Round with Monetary Policy Cycles
Most policy changes are implemented in small, incremental steps because central bankers would be in complete disarray if interest rates changed dramatically.
The mere possibility of such an event disrupting not only the individual trader but also the economy as a whole.
As a result, we typically see interest rate fluctuations of.25% to 1% at a time. Remember that central banks prefer price stability above shock and awe.
Part of this stability stems from the length of time required to effect these interest rate increases. It can take several months or even years.
Central bankers, like forex traders, collect and analyze data to determine their next move; however, they must base their decisions on the entire economy rather than a single trade.
Interest rate hikes might be compared to pushing on the brakes, while rate cuts can be compared to putting on the accelerator, but keep in mind that consumers and businesses react more slowly to these adjustments.
The time lag between monetary policy changes and their effects on the economy might range from one to two years.