Field Guide to Trading Terms

Monetary policy

Family IX · Macro

Not to be confused with central bank, quantitative easing, interest rate decision.

Monetary policy is conducted by a central bank, such as the Federal Reserve, the European Central Bank or the Bank of England, and operates through changes to interest rates, reserve requirements and asset purchases. Its objectives and the tools available to achieve them are set by national legislation and therefore differ across jurisdictions. Traders watch policy decisions and forward guidance because they affect borrowing costs, currency values and asset prices.[1]

How it works

Central banks adjust the cost and availability of credit. The primary tool is the policy interest rate: raising it tends to cool borrowing and spending, while lowering it tends to stimulate them. Additional tools include reserve requirements, which set the minimum cash banks must hold, and quantitative easing, which involves large-scale purchases of government or other securities to inject liquidity.

Policy is transmitted to the wider economy through several channels. Changes in the policy rate influence market interest rates, which affect consumer and business borrowing. They also influence asset prices, exchange rates and expectations of future inflation. The full effect on output and inflation typically appears with a lag that can range from several months to over a year.

Policy stance and examples

A central bank may adopt an expansionary stance, lowering rates or purchasing assets to support growth, or a contractionary stance, raising rates or selling assets to restrain inflation. The appropriate stance depends on the economic outlook and the bank's mandate, which may prioritise price stability, maximum employment or both.

Effect of a rate change on a loan
Initial loan$200,000 at 5.0%Annual interest = $10,000
Policy rate change+0.50%New rate = 5.5%
New annual interest$200,000 × 5.5%$11,000

Market relevance

Monetary policy decisions and the communication that accompanies them are closely watched by traders because they can move interest rate expectations, bond yields, currencies and equities. Scheduled meetings, minutes and speeches by policymakers are regular sources of volatility. The exact timing and content of these events vary by central bank and are published on official websites.

Often confused with

central bank
A central bank is a national institution that issues legal-tender currency, sets the base interest rate, and supervises the banking system, operating under a mandate that varies by country.
quantitative easing
Quantitative easing is a central bank policy of creating new reserves to purchase financial assets, primarily government bonds, in order to inject liquidity and lower long-term interest rates when conventional rate cuts are exhausted.
interest rate decision
An interest rate decision is the formal announcement by a central bank's policy committee of the target level for its policy interest rate, or of a change to that level, following a scheduled or ad hoc policy meeting.

See also

References

  1. ↑ Policy rate publications of the relevant central banks. Overnight financing follows the interest-rate differential between the two currencies, plus the broker's own markup, so the figure is not fixed.
Family: IX · Macro · Index A–Z