How Does Monetary Policy Impact Forex Currency?

That change is usually caused by many factors, among them, the most influential one is a particular nation's monetary policy, which adopted by central banks.

In this article, we will focus on the roles of the major central banks and how their policies affect the forex market.

What is Monetary Policy in Forex？

According to Investopedia, the Monetary policy is 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 in forex is a governments policy through the Central banks to control the amount of money in circulation. Its aim it to stablize prices and economic development.

The central banks operate under the rules of the government to regulate money circulation with a goal of achieving economic stability and development.

What Are the Responsibilities of Central Bank？

Central banks have been established to fulfil a mandate in order to serve the public interest. While responsibilities may differ between countries, the main responsibilities include the following:

1) Achieve and maintain price stability: Central banks are tasked with protecting the value of their currency. This is done by maintaining a modest level of inflation in the economy.

2) Promoting financial system stability: Central banks subject commercial banks to a series of stress testing to reduce systemic risk in the financial sector.

3) Fostering balanced and sustainable growth in an economy: In general, there are two main avenues in which a country can stimulate its economy. These are through Fiscal policy (government spending) or monetary policy (central bank intervention). When governments have exhausted their budgets, central banks are still able to initiate monetary policy in an attempt to stimulate the economy.

4) Supervising and regulating financial institutions: Central banks are tasked with the duty of regulating and supervising commercial banks in the public interest.

5) Minimize unemployment: Apart from price stability and sustainable growth, central banks may have an interest in minimizing unemployment. This is one of the goals from the Federal Reserve.

Different Types of Monetary Policies

Generally speaking, monetary policies can be divided into two categories as following:

1. Expansionary Monetary Policies

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, serving to promote spending and make money-saving relatively unfavorable.

Increased money supply in the market aims to boost investment and consumer spending. Lower interest rates mean that businesses and individuals can secure 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.

2. Contractionary Monetary Policies

Increased money supply can lead to higher inflation, raising the cost of living and cost of doing business. Contractionary monetary policy, 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 necessary to cool down the economy and keep it in check.

In the early 1980s when inflation hit record highs and was hovering in the double-digit range of around 15%, the Fed raised its benchmark interest rate to a record 20%. Though the high rates resulted in a recession, it managed to bring back inflation to the desired range of 3% to 4% over the next few years.

How Does Monetary Policy Affect Forex Market？

1. Currency Exchange Rates

Central banks of different nations have different policies and mandates as it relates to managing their currency. The US dollar, for example, is a freely floating currency. This is to say that the exchange rate policy of the the Federal Reserve is to not directly engage in the management of the value of the Dollar. Rather, it sets specific policies and measures to achieve its dual mandate. Countries such as China, on the other hand, actively manage their currency exchange rate.

So what happens when a central bank such as the Federal Reserve decides to raise its interest rates. Well, we know from our earlier discussion that this will have the effect of curtailing growth within the US economy.

When the Fed increases its interest rate, that often creates additional demand for the US dollar internationally.

As a result, rising interest rates can have the effect of increasing additional demand for a currency, which in turn will cause its exchange-rate to rise as well against other currencies.

The flip side of this is when the Fed decides to reduce the current interest rate.

2. Interest Rates

One of the biggest drivers of foreign-exchange rates is the interest rates set by central banks. As such, Forex traders need to be cognizant of scheduled meetings and announcements of major central banks around the world. The decisions that central bankers make can influence the price of a currency pair both in the short term and over the longer term time horizon as well.

Many major currency pairs will become extremely volatile immediately following an interest rate decision. This is especially true if the central bank acts contrary to what was unexpected by major economists and analysts. The price of a currency pair can spike up or down hundreds of pips in an instant when such an event occurs.

And the ramifications of an interest rate policy, be it a rate hike or rate cut, can be felt for weeks and months, as investors around the world digest the new information.

Money will often flow out of currencies that offer lower yield, and flow into currencies that offer higher yield. One popular strategy that many large hedge funds and institutions utilize in the foreign exchange market is the carry trade.

The carry trade seeks to purchase a currency with a high yield, and simultaneously sell a currency with a lower yield. The lower yielding currency is said to finance the higher-yielding currency.

Another method that forex traders can implement is to try to predict future central bank policy decisions. Fundamental analysts study the underlying economic conditions for a specific country or region in an effort to gauge what monetary policymakers are likely to do in the future.