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What is Monetary Policy?
Monetary policy consists of the process of drafting, announcing, and implementing the plan of actions taken by the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied. Monetary policy consists of management of money supply and interest rates, aimed at achieving macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. These are achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange rates, and changing the amount of money banks are required to maintain as reserves. Some view the role of the International Monetary Fund as this.
- Monetary policy is how a central bank or other agency governs the supply of money and interest rates in an economy in order to influence output, employment, and prices.
- Monetary policy can be broadly classified as either expansionary or contractionary.
- Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations (subject to the central bank’s credibility).
Understanding Monetary Policy
Economists, analysts, investors, and financial experts across the globe eagerly await the monetary policy reports and outcome of the meetings involving monetary policy decision-making. Such developments have a long lasting impact on the overall economy, as well as on specific industry sector or market.
Monetary policy is formulated based on inputs gathered from a variety of sources. For instance, the monetary authority may look at macroeconomic numbers like GDP and inflation, industry/sector-specific growth rates and associated figures, geopolitical developments in the international markets (like oil embargo or trade tariffs), concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible sources.
Monetary authorities are typically given policy mandates, to achieve stable rise in gross domestic product (GDP), maintain low rates of unemployment, and maintain foreign exchange and inflation rates in a predictable range. Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses to taxes, government borrowing, and spending to manage the economy.
The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal Reserve has what is commonly referred to as a “dual mandate”: to achieve maximum employment (with around 5 percent unemployment) and stable prices (with 2 to 3 percent inflation). It is the Fed’s responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low. Its core role is to be the lender of last resort, providing banks with liquidity and serve as a bank regulator, in order to prevent the bank failures and panics in the financial services sector.
Types of Monetary Policies
At a broad level, monetary policies are categorized as expansionary or contractionary.
If a country is facing a high unemployment rate during a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity. As a part of expansionary monetary policy, the monetary authority often lowers the interest rates through various measures that make money saving relatively unfavorable and promotes spending. It leads to an increased money supply in the market, with the hope of boosting investment and consumer spending. Lower interest rates mean that businesses and individuals can take loans on convenient terms to expand productive activities and spend more on big ticket consumer goods. An example of this expansionary approach is the low to zero interest rates maintained by many leading economies across the globe since the 2008 financial crisis. (For related reading, see “What Are Some Examples of Expansionary Monetary Policy?”)
However, increased money supply can lead to higher inflation, raising the cost of living and cost of doing business. Contractionary monetary policy, by increasing interest rates and slowing the growth of the money supply, aims to bring down inflation. This can slow economic growth and increase unemployment, but is often required to tame inflation. In the early 1980s when inflation hit record highs and was hovering in the double digit range of around 15 percent, the Federal Reserve raised its benchmark interest rate to a record 20 percent. Though the high rates resulted in a recession, it managed to bring back the inflation to the desired range of 3 to 4 percent over the next few years.
Tools to Implement Monetary Policy
Central banks use a number of tools to shape and implement monetary policy.
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First is the buying and selling of short term bonds on the open market using newly created bank reserves. This is known as open market operations. Open market operations traditionally target short term interest rates such as the federal funds rate. The central bank adds money into the banking system by buying assets (or removes in by selling assets), and banks respond by loaning the money more easily at lower rates (or more dearly, at higher rates), until the central bank’s interest rate target is met. Open market operations can also target specific increases in the money supply in order to get the banks to loan funds more easily, by purchasing a specified quantity of assets; this is known as quantitative easing.
The second option used by monetary authorities is to change the interest rates and/or the required collateral that the central bank demands for emergency direct loans to banks in its role as lender-of-last-resort. In the U.S. this rate is known as the discount rate. Charging higher rates and requiring more collateral, will mean that banks have to be more cautious with their own lending or risk failure and is an example of contractionary monetary policy. Conversely, lending to banks at lower rates and at looser collateral requirements will enable banks to make riskier loans at lower rates and run with lower reserves, and is expansionary.
Authorities also use a third option, the reserve requirements, which refer to the funds that banks must retain as a proportion of the deposits made by their customers in order to ensure that they are able to meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing the reserve requirement has a reverse effect, curtailing bank lending and slowing growth of the money supply.
In addition to the standard expansionary and contractionary monetary policies, unconventional monetary policy has also gained tremendous popularity in recent times. During periods of extreme economic crisis, like the financial crisis of 2008, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities by introducing news lending and asset purchase programs that combined aspects of discount lending, open market operations, and quantitative easing. Monetary authorities of other leading economies across the globe followed suit, with the Bank of England, the European Central Bank and the Bank of Japan pursuing similar policies.
Lastly, in addition to direct influence over the money supply and bank lending environment, central banks have a powerful tool in their ability to shape market expectations by their public announcements about the central bank’s own future policies. Central banks statements and policy announcements move markets, and investors who guess right about what the central banks will do can profit handsomely. Some central bankers choose to be deliberately opaque to market participants in the belief that this will maximize the effectiveness of monetary policy shifts by making them unpredictable and not “baked-in” to market prices in advance. Others choose the opposite: to be more open and predictable in the hopes that they can shape and stabilize market expectations in order to curb volatile market swings that can result from unexpected policy shifts.
However, the policy announcements are effective only to the extent of the credibility of the authority which is responsible for drafting, announcing, and implementing the necessary measures. In an ideal world, such monetary authorities should work completely independent of influence from the government, political pressure, or any other policy-making authorities. In reality, governments across the globe may have varying levels of interference with the monetary authority’s working. It may vary from the government, judiciary, or political parties having a role limited to only appointing the key members of the authority, or may extend to forcing them to announce populist measures (to influence an approaching election for example). If a central bank announces a particular policy to put curbs on increasing inflation, the inflation may continue to remain high if common public have no or little trust in the authority. While making investment decisions based on the announced monetary policy, one should also consider the credibility of the authority.
The Influence of Central Banks and Monetary Policies on the Trading Process
A central bank will buy or sell a currency in the foreign exchange market in order to increase or decrease the value its nation’s currency possesses against an alternative currency. This is known as currency intervention, central bank intervention, or more informally as Forex market intervention. When a country’s currency is enduring extreme and unnecessary upward or downward financial pressure, (usually caused by high volatility from a surge of trading by speculators and market players) a government or central bank will use Forex market intervention to stabilise the situation. Central bank intervention can be used to boost or decrease a currencies value, most commonly for the purpose of boosting and decreasing productivity and exports of a nation. There has been much criticism directed at governments who use market intervention excessively to amplify their currency’s value.
The most common reason for central bank intervention over the last decade or so would be because of a sharp or sudden decline in the value of a currency. It can however turn problematic for a nation to use market intervention whenever the currency value does decline steeply in the foreign exchange market and it will lead to several disadvantages to the nation. Export-dependent countries could spiral into recession if they become too reliant on market intervention. Global trading partners’ exchange rates will rise as well, while the prices of their exports increase within the global market place. A decline in value of a nations’ currency can also lead to an increase in inflation as prices of imported services and goods are will go up. Subsequently, interest rates will be augmented by the central bank but will unfortunately disturb the economic growth and asset markets, and possibly developing into a decline of the currency’s value. Nations with large budget deficits rely on foreign inflows of capital. A decline in the value of a currency can cause major financial difficulty to countries with high budget deficits. Financing the deficits will be extremely delayed and will jeopardize the economic growth of a nation. In order to maintain the value of the currency, there will need to be an elevation of interest rates.
It is imperative the central bank takes the correct measures without focussing entirely on the value of its currency; otherwise forex market intervention could potentially hurt the nations’ economy.
The four forms of market intervention
Although there are many forms of foreign exchange intervention, there are four which can be considered the most significant and frequent. They are Intervention, Operational, Concerted and Sterilized intervention. Intervention (‘jawboning’) is known to be less complex and cheaper than any other type of intervention as foreign currency reserves are not disrupted during the process. Representatives of the central bank and the Ministry of Finance negotiate over a currency by ‘talking up’ or ‘down’ about it. Through this, they determine a currency to be over or under valued.
The representatives can also use Operational intervention where concrete buying or selling of the currency takes place. Even though this form of intervention is considered a lot simpler than others, it is not however the most efficient and effective. For instance, it is not suitable for nations whose central banks intervene often; they are more likely to use verbal intervention so as to be more effective.
Concerted intervention can also be verbal so that many representatives from varying countries can unify and discuss apprehensions over a currency that may be continuously fluctuating. Through Concerted intervention, nations unify to escalate or lower specific currencies with the use of their individual foreign currency reserves. The effectiveness and success of this type of intervention relies on the amount of nations involved and the overall amount of intervention (known as the breadth and depth).
Sterilized Intervention involves a central bank using its monetary policy practices; doing so through adjusting its interest rate goals and its open market operations to intervene in the forex market. Another way of describing the event of sterilizing a currency is when a central bank sells market instruments to try and claw back excess funds. There is a possibility of Forex interventions to go unsterilized or perhaps slightly sterilized when performances in the currency market are aligned along with monetary policies as well as foreign exchange policies.
An occasion like this happened in the concerted interventions of the ‘Plaza Accord’. In September 1985, G7 went on to stem the extreme increase of the Dollar by buying the ‘Plaza Accord’s’ currencies and then selling the Dollar. From there on, Japanese deposits were considered better compared to the US. Japan’s short-term interest rates were raised by 200 bps and the 3-month Euro yen underwent a large increase of 8.25 %. Of course, this process turned out well as the monetary policies and foreign exchange policies were adopted.
A further example of this was in February 1987. The G7 collaborated with the ‘Louvre Accord’ in order to prevent the sinking of the Dollar. After this, the Federal Reserve became tightly accustomed to the monetary policies while the rates were increased by 300 pips reaching a peak level of 9.25% in September.
An example of a successful forex market intervention could be when a central bank uses an amount of USD 5 million on intervention and is then able to increase the currency value by around 2% in opposition to other currencies within thirty minutes. A move like this can seem threatening the next time a central bank wants to step in the market. Even the possibility of losing funds off a currency in another trading session does not seem as frightful to a central bank when the central bank is able to achieve a successful intervention in the Forex market. Important aspects of achieving such an intervention depend on timing, momentum, size and sterilization.
The enormity of an intervention coincides with the final move of a currency. The Bank of Japan holds $550 billion of Forex reserves while the European Central Bank holds $330 billion and the Bank of China holds $346 billion. As of 2003, these three central banks obtain the top most quantity of Forex reserves. It is essential that a central bank supplies a generous amount of foreign exchange currency reserves. The size of the currency intervention can determine the affect of the intervention and whether it was successful or not.
When grabbing a market player off guard with an intervention, it is more probable for them to be suddenly bundled with a huge inflow of orders. However, if the timing is wrong, and market players are expecting intervention, then the huge inflow of orders is better grasped although the effect is rather low.
As a currency is moving in the aimed direction of the intervention, it is the most ideal, suitable time to apply intervention. Since the Forex market has a volume of 1.2 trillion Dollars per day, the intervention of 3-5 billion Dollars seems too little; therefore central banks generally prefer to anticipate favourable currents rather than intervening against the market trend. Central banks do this through verbal posturing, which is a sort of indication given to traders of the upcoming intervention.
This is the procedure of when central banks abide by monetary policies alongside Forex market performances. Doing so generates a preferred long-term modification in the currency.
Forex traders are recommended to be cautious while selecting stop losses and while submitting an order during central bank interventions. It is advisable to consider levels of support as it is here where central banks intrude in order to affect a currency’s valuation. It is a golden rule in Forex trading never to trade against market intervention. The volume and power behind a central bank’s intervention is enough to significantly dent your trading account balance. Always try to be aware of the planned central bank intentions for market intervention, and plan your trading accordingly.
What Is a Central Bank?
A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.
Central banks are inherently non-market-based or even anti-competitive institutions. Although some are nationalized, many central banks are not government agencies, and so are often touted as being politically independent. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.
The critical feature of a central bank—distinguishing it from other banks—is its legal monopoly status, which gives it the privilege to issue bank notes and cash. Private commercial banks are only permitted to issue demand liabilities, such as checking deposits.
- A central bank is the financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates.
- Central banks enact monetary policy, by easing or tightening the money supply and availability of credit, central banks seek to keep a nation’s economy on an even keel.
- A central bank sets requirements for the banking industry, such as the amount of cash reserves banks must maintain vis-à-vis their deposits.
- A central bank can be a lender of last resort to troubled financial institutions and even governments.
Understanding Central Banks
Although their responsibilities range widely, depending on their country, central banks’ duties (and the justification for their existence) usually fall into three areas.
First, central banks control and manipulate the national money supply: issuing currency and setting interest rates on loans and bonds. Typically, central banks raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage monetary policy to guide the country’s economy and achieve economic goals, such as full employment.
Most central banks today set interest rates and conduct monetary policy using an inflation target of 2-3% annual inflation.
Second, they regulate member banks through capital requirements, reserve requirements (which dictate how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees, among other tools. They also provide loans and services for a nation’s banks and its government and manage foreign exchange reserves.
Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even a government. By purchasing government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to increase revenue.
Example: The Federal Reserve
Along with the measures mentioned above, central banks have other actions at their disposal. In the U.S., for example, the central bank is the Federal Reserve System, aka “the Fed”. The Federal Reserve Board (FRB), the governing body of the Fed, can affect the national money supply by changing reserve requirements. When the requirement minimums fall, banks can lend more money, and the economy’s money supply climbs. In contrast, raising reserve requirements decreases the money supply. The Federal Reserve was established with the 1913 Federal Reserve Act.
When the Fed lowers the discount rate that banks pay on short-term loans, it also increases liquidity. Lower rates increase the money supply, which in turn boosts economic activity. But decreasing interest rates can fuel inflation, so the Fed must be careful.
And the Fed can conduct open market operations to change the federal funds rate. The Fed buys government securities from securities dealers, supplying them with cash, thereby increasing the money supply. The Fed sells securities to move the cash into its pockets and out of the system.
A Brief History of Central Banks
The first prototypes for modern central banks were the Bank of England and the Swedish Riksbank, which date back to the 17 th century. The Bank of England was the first to acknowledge the role of lender of last resort. Other early central banks, notably Napoleon’s Bank of France and Germany’s Reichsbank, were established to finance expensive government military operations.
It was principally because European central banks made it easier for federal governments to grow, wage war, and enrich special interests that many of United States’ founding fathers—most passionately Thomas Jefferson—opposed establishing such an entity in their new country. Despite these objections, the young country did have both official national banks and numerous state-chartered banks for the first decades of its existence, until a “free-banking period” was established between 1837 and 1863.
The National Banking Act of 1863 created a network of national banks and a single U.S. currency, with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907. In response, in 1913 the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations. The new Fed helped finance World War I and World War II by issuing Treasury bonds.
Between 1870 and 1914, when world currencies were pegged to the gold standard, maintaining price stability was a lot easier because the amount of gold available was limited. Consequently, monetary expansion could not occur simply from a political decision to print more money, so inflation was easier to control. The central bank at that time was primarily responsible for maintaining the convertibility of gold into currency; it issued notes based on a country’s reserves of gold.
At the outbreak of World War I, the gold standard was abandoned, and it became apparent that, in times of crisis, governments facing budget deficits (because it costs money to wage war) and needing greater resources would order the printing of more money. As governments did so, they encountered inflation. After the war, many governments opted to go back to the gold standard to try to stabilize their economies. With this rose the awareness of the importance of the central bank’s independence from any political party or administration.
During the unsettling times of the Great Depression in the 1930s and the aftermath of World War II, world governments predominantly favored a return to a central bank dependent on the political decision-making process. This view emerged mostly from the need to establish control over war-shattered economies; furthermore, newly independent nations opted to keep control over all aspects of their countries – a backlash against colonialism. The rise of managed economies in the Eastern Bloc was also responsible for increased government interference in the macro-economy. Eventually, however, the independence of the central bank from the government came back into fashion in Western economies and has prevailed as the optimal way to achieve a liberal and stable economic regime.
Central Banks and Deflation
Over the past quarter-century, concerns about deflation have spiked after big financial crises. Japan has offered a sobering example. After its equities and real estate bubbles burst in 1989-90, causing the Nikkei index to lose one-third of its value within a year, deflation became entrenched. The Japanese economy, which had been one of the fastest-growing in the world from the 1960s to the 1980s, slowed dramatically. The ’90s became known as Japan’s Lost Decade. In 2020, Japan’s nominal GDP was still about 6% below its level in the mid-1990s.
The Great Recession of 2008-09 sparked fears of a similar period of prolonged deflation in the United States and elsewhere because of the catastrophic collapse in prices of a wide range of assets. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions throughout the United States and Europe, exemplified by the collapse of Lehman Brothers in September 2008.
The Federal Reserve’s Approach
In response, in December 2008, the Federal Open Market Committee (FOMC), the Federal Reserve’s monetary policy body, turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases, aka quantitative easing (QE).
The former involved cutting the target federal funds rate essentially to zero and keeping it there at least through mid-2020. But it’s the other tool, quantitative easing, that has hogged the headlines and become synonymous with the Fed’s easy-money policies. QE essentially involves a central bank creating new money and using it to buy securities from the nation’s banks so as to pump liquidity into the economy and drive down long-term interest rates. In this case, it allowed the Fed to purchase riskier assets, including mortgage-backed securities and other non-government debt.
This ripples through to other interest rates across the economy and the broad decline in interest rates stimulate demand for loans from consumers and businesses. Banks are able to meet this higher demand for loans because of the funds they have received from the central bank in exchange for their securities holdings.
Other Deflation-Fighting Measures
In January 2020, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros’ worth of bonds, at a monthly pace of 60 billion euros, through to September 2020. The ECB launched its QE program six years after the Federal Reserve did so, in a bid to support the fragile recovery in Europe and ward off deflation, after its unprecedented move to cut the benchmark lending rate below 0% in late-2020 met with only limited success.
While the ECB was the first major central bank to experiment with negative interest rates, a number of central banks in Europe, including those of Sweden, Denmark, and Switzerland, have pushed their benchmark interest rates below the zero bound.
Results of Deflation-Fighting Efforts
The measures taken by central banks seem to be winning the battle against deflation, but it is too early to tell if they have won the war. Meanwhile, the concerted moves to fend off deflation globally have had some strange consequences:
- QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war.
- European bond yields have turned negative: More than a quarter of debt issued by European governments, or an estimated $1.5 trillion, currently has negative yields. This may be a result of the ECB’s bond-buying program, but it could also be signaling a sharp economic slowdown in the future.
- Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling balance sheets to record levels. Shrinking these central bank balance sheets may have negative consequences down the road.
In Japan and Europe, the central bank purchases included more than various non-government debt securities. These two banks actively engaged in direct purchases of corporate stock in order to prop up equity markets, making the BoJ the largest equity holder of a number of companies including Kikkoman, the largest soy-sauce producer in the country, indirectly via large positions in exchange-traded funds (ETFs).
Modern Central Bank Issues
Currently, the Federal Reserve, the European Central Bank, and other major central banks are under pressure to reduce the balance sheets that ballooned during their recessionary buying spree (the top 10 central banks have expanded their holdings by 265% over the past decade).
Unwinding, or tapering these enormous positions is likely to spook the market since a flood of supply is likely to keep demand at bay. Moreover, in some more illiquid markets, such as the MBS market, central banks became the single largest buyer. In the U.S., for example, with the Fed no longer purchasing and under pressure to sell, it is unclear if there are enough buyers at fair prices to take these assets off the Fed’s hands. The fear is that prices will then collapse in these markets, creating more widespread panic. If mortgage bonds fall in value, the other implication is that the interest rates associated with these assets will rise, putting upward pressure on mortgage rates in the market and putting a damper on the long and slow housing recovery.
One strategy that can calm fears is for the central banks to let certain bonds mature and to refrain from buying new ones, rather than outright selling. But even with phasing out purchases, the resilience of markets is unclear, since central banks have been such large and consistent buyers for nearly a decade.
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