Monetary Policy Tools
Central banks are major monetary authorities that attempt to control the size and growth of money in several ways using Monetary Policy Tools. In the following Wiki on Monetary Policy Tools we will cover the types and kinds of tools that Central banks use to control and steer the economy in their desired direction.
In this Wiki we will look at the various tools the Central banks have at their disposal.
Central Bank Monetary Policy Tools
Ways to Manipulate the Money Supply
Central banks are major monetary authorities that attempt to control the size and growth of money in several ways:
- Interest Rates
- Price Controls
- Reserve Requirements
- Credit Control
- Central Banker Language
- Moral Suasion
- Open Market Operations
- Quantitative Easing
Understanding Interest Rates
Interest rates have “traditionally” been considered to be one of the primary tools a central bank will use in order to effectively manage the health of an economy.
If we break interest rates down into their most basic use we can say that they are generally used to attempt to control inflation within the economy. They are known as a “Traditional Monetary Policy Tool”. Interest rate changes are typically done by changing the “discount rate”.
Interest Rate Examples
As an example, if inflation is increasing faster than the central banks would like then the central bank will look to increase interest rates in order to try and slow the economy down. Because increasing interest rates increases the costs of doing business it ultimately discourages people from borrowing and spending.
Raising interest rates will also encourage people and companies to start saving their money. This has traditionally been used as an effective tool to reduce the rate at which inflation goes up.
On the other hand, if inflation is low or falling, the central bank will look to cut its interest rate. The idea is that this will discourage people from holding onto their money and start spending it. This actually encourages people and companies to start borrowing and spending more money within the economy. Investment and spending will generally pick up because companies and people can borrow money at lower interest rates than they could previously. This lowers the barrier for entry to more people and companies who may not have been able to borrow at the previous higher interest rates.
How the Forex Market Focuses on Interest Rates
Any hint that forces Forex traders to think that a central bank will adjust its interest rate either up or down can provide them with some excellent trading opportunities.
For example, if a certain central bank is indicating to the markets that it's thinking of cutting its interest rate then the market will go to work and attempt to price this new information into the currency. This is what creates some great trading opportunities to short that specific currency. We would want to look for short trades because we know that cutting interest rates is bad for currency valuations.
If a country cuts interest rates then large asset management companies will move their money out and into another country with higher yields. Money comes out of the currency which means selling, and selling means the price goes down.
What Forex traders do is look to trade in line with the central bank’s current and expected interest rate policies. This is one of the best ways traders can make money in Forex trading. Trade the 'current' situation for a bit of profit and trade the 'expectations' of the future for much bigger profits.
Interest rates are one of the biggest things that the Forex market will obsess over. If you think about it, a country's interest rate is the interest rate that you will be paid for holding that specific currency. As an example, if you are holding Great British Pounds long and the interest rate of the UK is currently 5% then this means that you will receive 5% per year just for holding Great British Pounds.
That sounds like a pretty simple way to make 5% per year and this is exactly how a lot of large asset management companies think. This is called a carry trade. The largest financial companies in the world are not trying to make 100% per year. If they can get 5-10% the bankers are all going to get massive bonuses.
The other big benefit of moving money into a high-interest rate paying currency is the potential for the currency to gain in value. This tends to happen as more and more investors want to own Great British Pounds to gain the high-interest rate in our example. Their buying of the currency naturally moves it higher over time.
One thing to keep in mind is that it’s not difficult to figure out what the market is thinking. How the markets are thinking will be plastered all over the news feeds on a daily basis. It really only takes a few minutes of scanning the news wires to figure out what the market is obsessing about today.
It’s also very easy to understand what the central banks are thinking because they will literally tell us in their press conferences and in other communications to the market. These are deliberately designed to keep the market in step with their policies so that they can control price stability within their country’s currency.
Almost all central bank meetings and press conferences are scheduled weeks in advance. Any decent economic calendar should have these clearly highlighted so that you are prepared for potential market-moving events.
Interest rates are a medium to longer-term tool because it typically takes time for the effect to filter through the economy. This is why central banks have many tools that they can use.
A price control is simply that. It is a way to control the price of a country’s currency. This can be done directly or indirectly by a central bank.
price controls happen when a central bank tells the market that it desires the price of its currency to be at a specific price level. If they are doing it “indirectly”, the central bank will simply communicate or threaten to act if the price moves too far away from where they want the price of their currency to be.
If the central bank decides to act “directly”, they will provide a very specific price level and make it clear that every time the price looks like it will breach their price limit they will step in and intervene to keep the price] in line with its target. They would typically intervene by buying up or selling huge amounts of their own native currency in the open market.
Swiss National Bank Price Control Example
An example of price control was when the Swiss National Bank (SNB) created a price floor for the Euro-Swiss (EURCHF) currency pair between 2011 and 2014. They felt it was in their best interest to not have the Swiss Franc appreciating against the Euro so they imposed a floor on the pair at a price of 1.2000.
They did this because the Eurozone is Switzerland’s largest trading partner. If the price of the EURCHF dropped too far this would have a negative impact on their exporting companies that relied on the higher value Euro as part of their ability to remain profitable.
If the price came close or broke the floor at 1.2000 the SNB would step in and intervene by literally buying up the currency pair. They would sometimes buy billions worth of Euros to make sure the price would not go below the 1.2000 handle.
The market did not believe the SNB at first but after several failed attempts to push the EURCHF pair below 1.2000 the market finally gave up and the price held consistently above the 1.2000 level for a couple of years.
This kind of action creates an interesting opportunity for a trader. If you have a central bank backing a trade to buy at a certain price level then this can create an opportunity to trade in line with the central bank with very little risk. The risk can be very low because a central bank can print money endlessly but the rest of the market cannot. Generally, the central bank will always win the battle because they just have so much more firepower.
The major risk to a trade like this is that the central bank can abandon its policy at any time without notice to the market. Guess what? In early 2015 the SNB removed the price floor very unexpectedly which sent the market into complete chaos as traders tried to find a new fair value for the EURCHF pair. You can see from the daily chart of the EURCHF that the price hung at or slightly above 1.2000 for a long time until the SNB pulled the rug out from under the market. It actually dropped about 2,300 pips or almost 40% in minutes!
This event wiped out a lot of traders who were relying on the SNB to hold the price floor at 1.2000. It even instantly put large well establish Forex brokers out of business because of the huge number of client accounts that went into the negative and could not be paid back.
One of the things that made this event so chaotic was the fact that only 3 days before the SNB pulled the price limit they actually went on record stating that they would defend the price limit with the “Utmost Conviction”. They communicated this to the market because this was at a time when the Euro was plummeting day after day on the back of the European Central Banks' decision to start a new quantitative easing program.
We can only guess that the SNB members did a little bit of math and decided it would cost too much money to defend the price limit given the terrible outlook of the Eurozone and the major devaluation that was taking place in the Euro.
Fixed price controls, such as the one the SNB used, are rare but less formal versions are more common. Often central banks will tell the market where they would like the price] of the currency to be. When they do this it’s a time that traders should be paying attention.
Reserve requirements are sometimes referred to as reserve ratios of asset ratios.
Reserve requirements are the requirements regarding the percentage amount of cash a bank must hold in reserve against deposits made by customers at their banks. This cash must be held physically in the bank's vaults or stored at the closest Central Bank.
Said another way, the reserve ratio is the portion of all depositors’ cash balances that the banks must physically have on hand as cash so that clients can make normal everyday withdrawals.
These requirements are set by the central bank of each nation and are one of the main tools of traditional monetary policy.
How Central Banks Use Reserve Requirements
When the economy is doing well and inflation is rising a central bank will look to increase the reserve requirement to keep inflation in line with their mandate. They do this to try and slow down lending which would ultimately slow down inflation because people and companies will likely borrow and spend less. However, this does serve the purpose of storing more cash at regional banks when times are good so that when the economy takes a turn for the worse there is plenty of cash on hand in the banks to cover the client needs. It also means that if a recession hits the central bank can lower the reserve requirements so that the regional banks can start lending that idle cash and hopefully stimulate the economy.
When inflation is falling the central bank might look to decrease the reserve requirement in an effort to pump extra money into the financial system. The hope is that the banks will use this extra money to start lending out to companies for capital projects. This in turn could decrease unemployment and put people back to work.
Consumer spending is a major component of GDP so if more people have jobs then there will be more people spending money which will show up in the consumer spending numbers.
You can find the current reserve ratios for most central banks around the world at the following link. You might be surprised just how little cash banks are actually required to hold onto.
Credit control happens when a central bank imposes limits on how financial institutions can lend out money to other businesses or consumers.
Credit control can also be used to set limits on the amount of money that regular consumers can borrow from financial institutions. The idea is that you don’t want everyday people leveraging up to levels that they might not be able to afford if the market environment changes.
This is different from the reserve ratio in that it looks to target things other than how much banks can loan out in total. It will typically come after a reserve requirement has been set. This is usually done by creating rules around how much debt-to-income ratio companies and consumers can comfortably afford to have.
Credit control is a strategy that attempts to only allow the more credit-worthy people and companies to borrow from financial institutions. The idea is that if an economy has too many people or companies borrowing money then there might be a high number that can’t afford to pay back what they have borrowed. Obviously, if there is a high percentage of people not paying back their loans then this can cause a pretty awful banking crisis just like the one we saw in the Great Recession that kicked off in 2007 in the United States.
Lending out too much money too quickly could lead to runaway inflation and destabilize the overall economy. It could also increase the number of people and companies declaring bankruptcy which is obviously not something that a central bank wants to happen.
Central Banker Language
Central bank language is simply the things the central bank “says” rather than what it “actually does”. By making statements to the public about what it would like the market to do and where it would like the price of the currency to be, the central bank hopes that the market will take this language as a sufficient threat of action and then trade in line with the central banks desired route.
This highlights why credibility with the overall market is so essential to a central bank. Think about it for a minute, if the market doesn’t believe that the central bank will follow through on its threats then the central bank has a much more difficult time influencing the markets.
If the market shrugs off what the central bank says then it makes for a much tougher job in dictating monetary policy. This is why most central bankers are extremely careful about what and how they say something in the public domain because the slightest slip-up can harm the central bank's credibility. It can also cause excessive price volatility which controlling price stability is something that most central banks are tasked with doing.
Most of the time language will have the desired effect but sometimes it does not. It’s at these times that the central bank may actually have to step into the market and take some kind of action so that the rest of the market believes they will follow through in the future. There is no better way to command the attention of the market than by stepping in and following through in a big way.
Moral suasion is similar to central banker language but differs in that they are not typically speaking to the market as a whole. This is where the central bank will attempt to persuade financial institutions to increase or decrease the amounts that they are lending to their clients. Said another way, moral suasion is a persuasion tactic used by a central bank to influence or pressure, but not force, financial institutions into doing what the central bank wants them to do.
This is easier than outright passing laws and is often something the central bank will try and use before they are forced to pass new laws. Passing new laws could take a long time to get done. Moral suasion can happen much quicker and is sometimes needed when times are looking particularly dark.
Some historical moral suasion tactics that have been used are:
- Closed-door meetings with bank directors
- Increased number and severity of inspections
- Appeals to community spirit
- General threats
Basically, moral suasion is when the central bank jawbones financial institutions into hopefully doing what they want without the central bank itself actually needing to enact a new policy.
Open Market Operations
Open Market Operations (OMO) refers to the buying and selling of “government securities” in the open market by a central bank. The central bank will do this in order to increase or decrease the amount of money in the overall banking system.
This is basically a quick way to control the money supply. If they want to add money into the market they will buy government securities from the marketplace. This puts money into the pockets of financial institutions. If they want to decrease the money supply they will sell more government securities to the marketplace. This takes money out of the pockets of financial companies.
In the United States, this is facilitated by the Federal Reserve (Fed). OMO is the most flexible and most common tool that the Fed uses to implement and control monetary policy in the United States. However, the discount rate is also used which is the rate at which banks borrow reserves from one another.
The Fed can use various forms of OMO, but the most common OMO is the purchase and sale of government securities. Buying and selling government bonds allows the Fed to control the supply of reserve balances held by banks.
If a central bank purchases government securities in the open market this will have the effect of injecting money into the banking system. This is because when a central bank buys something the money comes off the central bank’s balance sheet and into the financial companies’ balance sheets. This is different from a normal business-to-business transaction where money simply changes hands.
If the central bank decides to sell government securities in the open market this will take money out of the banking system. When a business buys something from the central bank it takes money off its balance sheet and transfers it to the central bank’s balance sheet. This means that this money from the business is no longer available in the money supply until the central bank decides to put it back into the economy.
Open market operations are a tool that central banks will use as a fast-acting tool. This is because they can literally control how much money is in the banking system as long as other participants are willing to buy and sell from the central bank at that time.
Quantitative easing has rarely been used with any significance throughout most of central banking history. However, there is the exception of the global financial crisis that started in 2007 and the subsequent global fallout. Several central banks are still using QE to support their economies at the time of this writing.
Quantitative easing is viewed as an unconventional monetary policy tool that many central banks use only as a last resort if the more traditional tools such as interest rates are not having the desired effect on the economy.
QE is the process of printing money and injecting that money into the financial system. This is usually done in the form of buying government securities and other government-linked financial assets. The central bank purchases these back from the companies that hold them so that those companies will have more money on their books. The idea is that these companies will use that extra money to pump into loans for capital projects within the economy.
This is done to hopefully lower interest rates that financial institutions charge and increase the money supply by flooding the financial system with fresh capital. This is an effort to promote increased lending and make sure there is enough of the vital liquidity that the market needs to function properly.
When the central bank does QE it serves to add more liquidity to the financial system so that it remains stable during hard economic times. A central bank would only consider performing QE when interest rates are at or approaching 0% and the economy is not looking like it will meet the central bank's inflation targets. If the central bank is considering QE then they are probably more concerned with deflation rather than inflation.
If a QE strategy is not having the desired effects then the central bank will look to target commercial banks and private sector assets rather than only buying government securities and bonds. This is when you know the economy is really unstable and has a lot of issues to sort out. Effectively, if the central bank starts buying public sector debts and assets then you know that they are extremely concerned about a potential depression rather than just a recession. Think about that; a central bank doesn’t want to own unstable public assets with an uncertain future when it could own its own debt but hard times call for major measures to be taken.
Quantitative easing serves the purpose of stimulating growth and investment because there is so much fresh and cheap money going around. It can also devaluate the currency because more supply is being printed faster than the natural rate of demand is able to absorb it. This currency devaluation further encourages growth as the country’s exporters become much more competitive which is good for the economy overall.
Generally speaking, QE has proved itself to be extremely effective so when the central bank threatens to or actually implements QE the market will pay very close attention.
Final Thoughts on Central Bank Tools
When a central bank implements any of these tools it gives Forex traders the opportunity to potentially find a profitable trade. All you need to do is be tuned into what is going on with the economic indicators that the central banks are watching and then listen to what the central bank is telling the markets about those indicators.
The question traders should be asking is; Is the central bank happy or concerned with a particular indicator? They will tell us! This will prepare you extremely well to seize excellent trading opportunities as they come up.
You might be thinking that this all sounds very simple; you get the concepts and understand that it’s the central bank's actions that cause most of the price moves in the Forex market. But you might be wondering how you will figure out exactly what the central bank is thinking of doing. Surely this is important information to be aware of if the central banks play such a big role in the Forex market. This is a fairly simple process because the central bank will rarely focus on more than one or two specific things at any one time. This makes it much easier to track and understand what is going on right now.
For example, if the central bank is worried about inflation being too low they will express this concern to the market. As traders, we know that there is a good chance they will cut interest rates in order to fight the falling inflation rate. This is the information traders can trade in line with. Cutting interest rates or the 'expectation' of falling interest rates will have a negative impact on the particular currency.
In this scenario, traders can forget all about production or housing data because we know that the central bank is now looking at low inflation as a primary concern. Traders will need to focus on inflation-related data and anticipate the central bank using tools associated with inflation. In this case, the tool would be interest rate cuts. Traders can then determine how that action will impact the currency and trade in line with it.
The central bank will express this information in what is called “forward guidance”. Forward guidance is the act of the central bank telling the market its intentions so as to not cause irrational price instability when they do make a policy adjustment.
Most central banks will leave little breadcrumbs for the market to pick up on. They typically won’t outright tell the markets their exact plans because that would cause too much immediate price volatility. Instead, what they do is leave a trail of hints and clues in the weeks and months going into a policy change. This way the impact on the market is minimized and happens gradually rather than abruptly causing price shocks.
If traders focus on what the central bank is focusing on then their trading becomes much simpler. Focus on the indicators, focus on the central bank, and once traders know what the central bank is focusing on we can then they can figure out what tools they could possibly use and how it will impact the markets.