Learning Fundamental Forex Analysis – Central Bank Monetary Policy

We previously mentioned that monetary policy refers to the measures taken by governments or central banks to influence economic activity, particularly those controlling money supply and regulating interest rates, to achieve specific or maintain policy goals—such as curbing inflation, achieving full employment, or promoting economic growth.

Central banks and monetary policy are inseparable; when discussing one, we inevitably touch upon the other.

Although some missions and objectives are shared among different central banks, due to economic differences, each central bank also has its unique policy goals.

The ultimate objectives of monetary policy are to maintain price stability and promote economic growth.

To achieve these goals, central banks use monetary policy to control the following aspects:

• Interest rates

• Inflation

• Money supply

• Reserve requirements

• Discount window lending

Categories of Monetary Policy
Monetary policy can be divided into different categories. If a central bank reduces the money supply or raises interest rates, it is called contractionary monetary policy.

The purpose of contractionary monetary policy is to curb excessive economic growth. Higher interest rates increase borrowing costs, thereby reducing consumption and investment.

On the other hand, if the money supply is increased or interest rates are cut, it is called expansionary monetary policy. The goal of rate cuts is to stimulate consumption and investment.

Expansionary monetary policy aims to boost economic growth by lowering interest rates or increasing money supply, while contractionary monetary policy seeks to curb inflation or prevent an overheated economy.

Finally, neutral monetary policy aims neither to stimulate growth nor suppress inflation.

One key point to remember is that central banks typically set an inflation target of 2%.

Some central banks may not explicitly state their inflation target, but their monetary policy operations strive to keep inflation within a reasonable range.

They understand that moderate inflation benefits the economy, but excessive inflation can undermine confidence, employment, and ultimately people’s wealth.

By setting an inflation target, market participants can better anticipate how central banks will respond to current economic conditions.

For example, in January 2010, the UK’s annual inflation rate rose to 3.5%, up from 2.9% the previous month. Since the Bank of England’s inflation target was 2%, the 3.5% rate was significantly above the target.

To reassure the market, then-Governor Mervyn King stated that temporary factors had driven inflation higher and that it would decline in the short term, so the central bank would not take special action.

Whether his statement proved correct is not our focus here; the key takeaway is that investors are in a better position when they understand the central bank’s policy intentions.

Simply put, traders prefer stability, central banks prefer stability, and economies thrive on stability. Understanding inflation targets helps traders comprehend why central banks adopt different monetary policies.

Monetary Policy Cycle
In most cases, central banks adjust monetary policy incrementally because rapid interest rate changes could disrupt markets.

Sharp shifts in monetary policy within a short period not only negatively impact traders but also shock the economy.

This is why interest rate adjustments are typically in the range of 0.25%-1.0%. Again, central banks aim for price stability and seek to avoid extreme market volatility.

Central banks’ preference for policy stability means that significant interest rate changes take a long time—months or even years.

Just as traders analyze data to guide their trading decisions, central banks conduct similar analyses, but their focus is on the entire economy rather than a single trade.

Central bank rate hikes act like braking, while rate cuts act like accelerating, but remember that consumers and businesses react slowly to interest rate changes.

The time lag between monetary policy changes and their actual economic impact is typically 1 to 2 years.