Monetary Policy

Understanding a currency’s strength goes beyond the rates of inflation and interest. Yes, those factors are important metrics in asset strength, but those metrics are influenced by something greater. That being the Federal Reserve in the US, the European Central Bank in Europe, Bank of Japan in Japan or any nation’s central bank. Central banks play a vital role in the way investors interpret the current and future power of tender, intrinsically and comparatively to other countries.

By the end of this, you will hopefully have an understanding of monetary policy and the meaning behind the motives of central banks.

What is Monetary Policy?

To put simply, monetary policy is the way a federal bank directs money supply, demand, debt, and reserve ratios. Monetary policy is planned through a series of meetings throughout the year. At every meeting, members of these committees discuss the overall state of the economy and what they plan to do going forward. Depending on the economy, the committee will determine to either be more or less focused on a currency’s strength or the economy’s strength.

Money Supply

Demand

Debt

Reserve Ratios

Have you ever heard the terms “hawkish” and “dovish”?

Here are the key differences between a hawkish and dovish central bank:

Hawkishness

Hawkishness is when a central bank becomes more focused on strengthening their country’s tender. In periods of expansion, a central bank will be more encouraged to take a hawkish stance on their currency. This is done through the manipulation of interest rates and money supply. Although money supply is done by the treasury system in the US, the Fed can still influence the printing of money to help stimulate the economy. Iff a central bank wanted to raise interest rates, this would make borrowing costs higher, mortgage rates higher, decrease consumer spending, and cause what is called an economic contraction. Although this might seem counterintuitive on the surface, it’s meant to help the economy in the long term as it brings more value to the nation’s dollar by bringing inflation down. In the US, the Federal Reserve is in the middle of an unwinding process which entails bringing interest rates higher to battle an concerningly high inflation rate caused by economic stimulus during the 2020 pandemic. In the short term, hiking interest rates will cause some sort of economic slowdown, but it is intended to keep the economy from collapsing in the long run. After all, high inflation is one thing that will destroy a nation’s domestic GDP and hurt international trade. There are times for both expansion and contraction which is why monetary policy is a countercyclical process. It’s all a balancing act to maintain a healthy equilibrium between a nation’s economic strength and dollar demand.

Figure 1: The Monetary Policy Cycle

Dovishness

On the other end of the cycle, expansionary policy is when a central bank becomes more dovish. In a dovish environment, interest rates are low or in the process of lowering to help the economy grow. Companies will usually thrive in dovish periods, overall spending will increase, mortgage rates will be lower, and more money will flow through the economy. In 2020, interest rates were near zero percent, and the economy/stock market flourished on bounteous tender fueled by the Fed. During this period, there were low rates of interest and mortgage, consumer spending was higher, and the economy experienced a period of expansion. This was done to prevent a temporary economic collapse. In other words, the US experienced an unprecedented contraction which prompted the Fed to act in a dovish manner.

Fed Tracker

Figure 2: The A1 EdgeFinder's Fed Tracker

One way to interpret a central bank’s sentiment is by looking at their forecasts of inflation and interest rates over time. This way, investors can get an idea of future rate hikes or cuts. If a central bank forecasts higher interest rates, we can interpret that as a more hawkish stance. If interest rates are projected to fall, we can interpret dovish sentiment. In figure 1, two charts are tracking the Fed’s projections on inflation and interest for the next four quarters provided by the EdgeFinder. In this particular case, inflation is expected to fall to three percent by Q1 of 2024. All the while, interest rates are projected to remain the same until Q1 of 2024 where there is a rate cut to four and three-quarters percent. Because markets are forward-looking, projections are key elements in fundamental trading. Lower interest rates over time evokes investors to buy risk-on assets while higher projected interest rates cause investors to buy risk-off assets.

Monetary Policy

Takeaways

Central banks influence the strength of a nation’s currency

Monetary policy is a countercyclical process

Hawkishness is when a central bank becomes more focused on currency strength

Dovishness is when a central bank becomes more focused on economic strength

Central bank projections of interest rates and inflation are essential in fundamental trading

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