Monetary policy is the most potent way for a country to reach its specific mandate or goals. A country's central bank determines the monetary policy independently without government interference, except in countries like China.
Monetary policy is the procedure involved in setting the interest rate and controlling money supply. There are three main objectives of the central bank’s monetary policy:
- A high to medium inflation rate
- Economic growth projections
- Greater employment and the creation of more jobs by giving commercial debts (loans with a flat interest rate/fee) to investors for business acquisition
The central bank usually increases interest rates to prevent an economy from bursting by stopping inflation from climbing too high. They can decrease the interest rate of the economy to stimulate GDP growth and avert deflation.
The monetary policy can be referred to either hawkish or dovish. Hawkish and dovish policies strongly affect currency rates via a system the central bank calls “forward guidance.”
The image above shows dovish and hawkish market moving potential.
What is a hawkish monetary policy?
The term “hawkish” describes the contraction of a country's economy. A hawkish monetary policy indicates high interest rates. It often refers to a situation where the central bank tightens the financial state of an economy as a way to slow it down at the start of higher inflation.
For example, in a hawkish scenario where the interest rates are rising, borrowing money becomes more expensive due to high interest rates. This causes spending and investing to decrease as a result.
Some of the terms used to describe a hawkish monetary policy include:
- Inflation rising
- Consistent economic growth
- Clearing/reducing the central bank’s balance sheet
- Price hikes
- Tightening of monetary policy
Generally, any word that is indicative of a high inflation rate, strong economic growth, and high interest rates indicates a more hawkish policy outcome.
What is a dovish monetary policy?
A dovish monetary policy is the opposite of a hawkish one. It indicates a falling interest rate situation. The central bank loosens the monetary policy by slashing interest rates to stimulate a stagnating economy.
For example, in a dovish scenario where interest rates are dropping, money is more accessible and affordable to consumers and businesses, which encourages more spending and investing. It’s the spending that eventually shakes off the stagnancy of an economy.
Some of the terms used to describe a dovish monetary policy include:
- Negative inflation
- Increasing the central bank’s balance sheet
- Loosening of monetary policy
- Interest rate cuts (a good season for those wanting to use loans to build businesses and create jobs)
- Weak economic growth
The table below shows how both policies differ in the forex market and how they affect currency pairs:
Hawkish Monetary Policy
Dovish Monetary Policy
|When interest rates increase, currency appreciates as the capital moves towards a higher interest rate currency.||When interest rates decrease, the currency tends to depreciate as it flows to a lower interest rate currency|
|When the Federal Reserve balance sheet reduces by selling Mortgaged Backed Securities and treasuries, the currency appreciates as the selling of MBS and treasuries increases interest rates.||When the Federal Reserve Balance sheet increases through quantitative easing, QE is the buying of MBD and treasuries to bloat the economy. The currency depreciates as the increase in the money influx decreases the demand for a currency.|
|When the forward guidance from CB includes positive statements of inflation, the currency appreciates as traders predict further interest rate hikes.||When the forward guidance from CB includes negative comments of deflation, the currency depreciates as traders predict further interest rate cuts.|
How traders trade a hawkish or dovish CB
Traders frequently observe the Federal Open Market Committee minutes to search for changes in terms that suggest an interest rate cut or hike and take advantage of such data.
For example, in a rate hike cycle, traders watch for signals and economic data that shifts the tone of the policy to either a higher hawkish or dovish policy.
Similarly, in a rate cut cycle, traders monitor the forward guidance and economic data for clues on the current policy state to determine whether it is becoming dovish or hawkish.
The bottom line
The central bank uses these types of monetary policies to smooth the gaps between the good and bad times an economy faces. Traders need to understand that both systems are vital tools for stabilising the economy; all they need to do is spot the currency direction.