Monetary policies are a set of actions undertaken by the central bank or other regulatory bodies to control the supply of capital to the public. Policies include measures to maintain a healthy flow of credit, so that there is a stability in price and increased trust in the currency.
As the monetary policy of a country can have a major impact on its economy and citizens. various analysts, financial experts and economists around the world take a deep interest in the release of monetary policy reports. They also actively follow the outcomes of meetings between officials that are aimed at decision making. Any developments on this front could have a long-lasting impact on the entire economy as well as on a particular market or industry.
To understand how monetary policies impact investors, let’s explore the various aspects related to it.
Monetary policy typically aims at achieving a constant rise in the Gross Domestic Product (GDP), maintaining foreign exchange rates, keeping unemployment at low levels and managing inflation. However, the primary objective is to first reduce inflation and then work towards reducing unemployment. This is because if inflation is left unchecked, it would impact the entire economy.
In the United States, the Federal Reserve is at the helm of making monetary decisions for the nation. The Fed follows a “dual mandate,” under which it aims to attain a state of maximum employment (with unemployment rates as low as 5%) and stable prices (with around 2%-3% inflation). So, in the US, it is the Fed’s responsibility to strike a balance between inflation and economic growth. Similar functions are assigned to the Bank of England, European Central Bank, Bank of Japan and so on.
Broadly speaking, monetary policy can be classified into two main types:
In case a country is facing high unemployment, due to a recession or slowdown of the economy, the expansionary policy comes into play. The monetary authority’s main objective in such a situation is to expand the economic activity and increase economic growth by putting money into the market. To do this, central banks normally decrease interest rates on loans as well as on savings. One such occasion when this policy was followed globally was after the 2008 financial crisis. Many leading economies decreased their rates, some to as low as zero, adopting an expansionary approach.
An expansionary policy leads to two major changes. Firstly, individuals and businesses in need of financial assistance to set up or expand their business can take loans at convenient rates. An indirect impact of this is a decrease in unemployment rate, as businesses begin to hire people for expansion.
Secondly, low interest rates mean lesser benefits for accumulating money in bank accounts. This causes more people to look for avenues of gaining profit, leading to increased investments in the stock market, forex market and other financial markets.
This is the exact opposite of an expansionary policy and mainly aims at controlling and lowering the inflation rate. This is because high inflation can spell trouble for both companies and individuals, since it leads to an increase in the cost of doing business as well as the cost of living. Here, the monetary authority increases the interest rates, so that there is less availability of money for spending. This step can have negative impacts in the form of slower economic growth and increase in unemployment. But it is necessary to reduce inflation at the expense of these two.
In the 1980s, when the inflation rate was as high as 15% in the US, the Fed had increased its benchmark rate to a record 20%. Although such a high interest rate led to recession, it also managed to lower the inflation rate to an optimum range of 3%-4%, for the next few years.
Apart from increasing or decreasing interest rates, central banks also have other strategies through which they implement monetary policies.
Central banks buy and sell short term bonds on the open market through newly created reserves. This activity is known as open market operations. Central banks add capital in the banking system with the purchase of assets and remove capital by selling assets. In return, banks give loans more easily at lower interest rates or make it difficult to get loans by setting high rates, until the point when the target interest rate of the central bank is achieved.
Another type of open market operation is quantitative easing. Here, the target is to increase money supply by a specific amount (through the purchase of assets) so that banks can make it easier to get loans.
Reserve requirements are the funds that all banks must maintain as part of the deposits made by their customers, to ensure they are able to meet their liabilities. Decreasing reserve level requirements helps to increase the availability of capital to banks. This enables them to offer higher loans to people or to buy the required assets.
Although this is a good step, it comes with some reverse effects of its own. Bank lending can decline and a reduction in the growth of money supply could occur due to a decrease in the reserve requirement levels.
Other than these standard methods, some unconventional monetary policies have also become increasingly popular across the world. For instance, during the financial crisis of 2008, the Fed filled its balance sheet with trillions of dollars’ worth of treasury notes and mortgage backed securities through the introduction of programmes that combined the aspects of quantitative easing, open market operations and discount lending. Central banks across the globe followed suit, with the Bank of Japan, Bank of England and European Central Bank implementing similar policies.
One very important tool in the hands of central banks is the public announcement of future monetary policies. This shapes market expectations and helps investors predict where to place trades, based on the upcoming changes in policy. Some central banks don’t give away their cards and want a sense of unpredictability to prevail in the movement of market prices, while others are more transparent and aim at reducing the occurrence of market swings that could occur due to sudden policy changes.