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How does monetary policy affect the Forex market?

How does monetary policy affect the Forex market?
Asked by
Jane Goodwin categorie-icon time-icon1 year ago
1 Answer Answer Question

Justin Freeman
Answered time-icon4 months ago

Monetary policy in each country is set by their respective central banks and is formulated to achieve a specific economic mandate. With central banks and monetary policy so inextricably intertwined there’s no way to talk about one without also talking about the other.

Because monetary policy is directly tied to interest rates, inflation and economic growth, it has a major impact on forex markets. Even a hint from central banks that monetary policy will change can cause huge moves in currencies.

You’ll find that some of the mandates held by the world’s central banks are similar, however, each one has its own unique and distinctive goals that are developed based on the specifics of that country’s economy.

No matter what the goals and mandates of a central bank might be, monetary policy is concerned mostly with maintaining and promoting price stability, along with encouraging economic growth.

Central banks have several tools they use to achieve their goals:

    • Money supply
    • Inflation
    • Interest rates
    • Bank reserve requirements
    • Lending to commercial banks

 

Economies, markets and traders all like stability. When central banks can give them stability through the tools at their disposal currencies will also remain fairly stable.

Types of Monetary Policy

Monetary policy is described in several ways. Each has a different impact on forex markets based on the activities being performed by the central bankers.

Monetary policy is called restrictive when the central bank is actively reducing the money supply. A monetary policy is also considered restrictive when the central bank is raising interest rates. The term restrictive is used because both of these actions make it harder, or more restrictive, to borrow money. The net effect is that business and consumers both reduce their investment and spending.

A country’s currency will often become stronger when monetary policy is restrictive. Higher interest rates encourage foreign investment, and a reduced money supply is a reduction in supply, which can drive the value of currencies higher.

The opposite of restrictive monetary policy is expansionary monetary policy. This is when the money supply is increased, or the interest rate is being decreased. This will often lead to a weaker currency as supply increases and demand decreases.

Related to expansionary monetary policy is accommodative monetary policy, which seeks economic growth through lowered interest rates to spur borrowing, spending and investing. The opposite of accommodative monetary policy is tight monetary policy, where interest rates are increased to restrain economic growth and reduce inflation.

Accommodative monetary policy encourages a weaker national currency, while tight monetary policy creates a stronger currency. This was clearly seen in many world economies following the 2007-2009 financial crisis when many central banks became extremely accommodative, and currency values fell sharply.

And finally there is neutral monetary policy, where the central bank is looking to maintain growth and inflation at their current levels.

It’s important to note that central banks do not directly set inflation rates, but that they generally have an inflation target which they try to reach through the means at their disposal. In many cases this inflation target is 2%.

Central bankers use inflation targets to let markets know how they plan on dealing with changes in their country’s economy. They know some inflation is helpful for growth, but too much or too little inflation will cause the economy to either overheat or remain stagnant.

It’s interesting to note that forex markets don’t need the central bank to actually make changes to monetary policy to react. Currency values can change dramatically simply based on comments made by central bank members during speaking engagements.

For example, the head of the Federal Reserve is closely watched. If he says that he feels the economy is getting too strong markets will take this as a sign that monetary policy will become more restrictive in the future. The U.S. dollar would most likely strengthen against rival currencies as a result.

That will happen even if monetary policy remains quite accommodative at the time. Traders try to anticipate what the central banks will do with monetary policy far in advance of when it actually occurs. It’s often not as important what actually happens versus what markets believe will happen.

In the U.S. there are even Federal Funds futures where traders can speculate on future interest rates. And there’s also a related FedWatch Tool that shows the probability of interest rate hikes or cuts based on the Fed Funds futures.

In Conclusion

Because monetary policy deals with changes in money supply and interest rates it has an often huge impact on the forex market. Even rumors or hints of changes to monetary policy can cause massive moves in currency values.

In some cases this is very useful information for traders, because it gives them a long-term picture for the forex market. For example, if monetary policy is expected to raise interest rates consistently over the next 18-24 months there’s a good chance that the currency will get consistently stronger over that time frame as well. This knowledge can help traders plan their trades.

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