As we
mentioned earlier, national governments and their corresponding central banking
authorities formulate monetary policy to achieve certain economic mandates or
goals.
Central
banks and monetary policy go hand-in-hand, so you can't talk about one without
talking about the other.
While
some of these mandates and goals are shared by the different central banks.
Central banks have their own unique set of goals brought on by their
distinctive economies.
Ultimately,
monetary policy boils down to promoting and maintaining price stability and
economic growth.
To
achieve their goals, central banks use monetary policy mainly to control the
following:
·
the interest rates tied to the cost of money,
·
the rise in inflation,
·
the money supply,
·
reserve requirements over banks,
·
and discount window lending to commercial banks
Types of Monetary Policy
Monetary policy can be referred to in a couple different ways. Contractionary or restrictive monetary policy takes
place if it reduces the size of the money supply. It can also occur with the
raising of interest rates.
The idea
here is to slow economic growth with the high interest rates. Borrowing money
becomes harder and more expensive, which reduces spending and investment by
both consumers and businesses.
Expansionary
monetary policy, on the other hand, expands or increases the money supply, or
decreases the interest rate.
The cost
of borrowing money goes down in hopes that spending and investment will go up.
Accommodative
monetary policy aims to create economic growth by lowering the interest rate,
whereas tight monetary policy is set to reduce inflation or restrain economic
growth by raising interest rates.
Finally,
neutral monetary policy intends to neither create growth nor fight inflation.
The
important thing to remember about inflation is that central banks usually have
an inflation target in mind, say 2%.
They
might not come out and say it specifically, but their monetary policies all
operate and focus on reaching this comfort zone.
They know
that some inflation is a good thing, but out-of-control inflation can remove
the confidence people have in their economy, their job, and ultimately, their
money.
By having
target inflation levels, central banks help market participants better
understand how they (the central bankers) will deal with the current economic
landscape.
Let's
take a look at an example.
Back in
January of 2010, inflation in the U.K. shot up to 3.5% from 2.9% in just one
month. With a target inflation rate of 2%, the new 3.5% rate was well above the
Bank of England's comfort zone.
Mervyn
King, the governor of the BOE, followed up the report by reassuring people that
temporary factors caused the sudden jump, and that the current inflation rate
would fall in the near term with minimal action from the BOE.
Whether
or not his statements turned out to be true is not the point here. We just want
to show that the market is in a better place when it knows why the central bank
does or doesn't do something in relation to its target interest rate.
Simply
put, traders like stability.
Central
banks like stability.
Economies
like stability. Knowing that inflation targets exist will help a trader to
understand why a central bank does what it does.
Round and Round with Policy Cycles
For those
of you that follow the U.S. dollar and economy (and that should be all of
you!), remember a few years back when the Fed increased interest rates by 10%
out of the blue?
It was
the craziest thing to come out of the Fed ever, and the financial world was in
an uproar!
Wait, you
don't remember this happening?
It was
all over the media.
Petroleum
prices went through the roof and milk was priced like gold.
You must
have been sleeping!
Oh wait,
we were just pulling your leg!
We just
wanted to make sure you were still awake. Monetary policy would never
dramatically change like that.
Most
policy changes are made in small, incremental adjustments because the bigwigs
at the central banks would have utter chaos on their hands if interest rates
changed radically.
Just the
idea of something like that happening would disrupt not only the individual
trader, but the economy as a whole.
That's
why we normally see interest rate changes of .25% to 1% at a time. Again,
remember that central banks want price stability, not shock and awe.
Part of
this stability comes with the amount of time needed to make these interest rate
changes happen. It can take several months to even several years.
Just like
traders who collect and study data to make their next move, central bankers do
a similar job, but they have to focus their decision-making with the entire
economy in mind, not just a single trade.
Interest
rate hikes can be like stepping on the brakes while interest rate cuts can be
like hitting the accelorator, but bear in mind that consumers and business
react a little more slowly to these changes.
This lag
time between the change in monetary policy and the actual effect on the economy
can take one to two years.
