411 on Monetary Policy

As we mentioned earlier, national governments and their corresponding central banking authorities formulate monetary policy to achieve certain economic mandates or goals.

Central banks and monetary policy go hand-in-hand, so you can't talk about one without talking about the other.

While some of these mandates and goals are shared by the different central banks. Central banks have their own unique set of goals brought on by their distinctive economies.

Ultimately, monetary policy boils down to promoting and maintaining price stability and economic growth.

To achieve their goals, central banks use monetary policy mainly to control the following:

• the interest rates tied to the cost of money,
• the rise in inflation,
• the money supply,
• reserve requirements over banks,
• and discount window lending to commercial banks

Types of Monetary Policy

Monetary policy can be referred to in a couple different ways. Contractionaryor restrictive monetary policy takes place if it reduces the size of the money supply. It can also occur with the raising of interest rates.

The idea here is to slow economic growth with the high interest rates. Borrowing money becomes harder and more expensive, which reduces spending and investment by both consumers and businesses.

Expansionary monetary policy, on the other hand, expands or increases the money supply, or decreases the interest rate.

The cost of borrowing money goes down in hopes that spending and investment will go up.

Accommodative monetary policy aims to create economic growth by lowering the interest rate, whereas tight monetary policy is set to reduce inflation or restrain economic growth by raising interest rates.

Finally, neutral monetary policy intends to neither create growth nor fight inflation.

The important thing to remember about inflation is that central banks usually have an inflation target in mind, say 2%.

They might not come out and say it specifically, but their monetary policies all operate and focus on reaching this comfort zone.

They know that some inflation is a good thing, but out-of-control inflation can remove the confidence people have in their economy, their job, and ultimately, their money.

By having target inflation levels, central banks help market participants better understand how they (the central bankers) will deal with the current economic landscape.

Let's take a look at an example.

Back in January of 2010, inflation in the U.K. shot up to 3.5% from 2.9% in just one month. With a target inflation rate of 2%, the new 3.5% rate was well above the Bank of England's comfort zone.

Mervyn King, the governor of the BOE, followed up the report by reassuring people that temporary factors caused the sudden jump, and that the current inflation rate would fall in the near term with minimal action from the BOE.

Whether or not his statements turned out to be true is not the point here. We just want to show that the market is in a better place when it knows why the central bank does or doesn't do something in relation to its target interest rate.

Simply put, traders like stability.

Round and Round with Policy Cycles

For those of you that follow the U.S. dollar and economy (and that should be all of you!), remember a few years back when the Fed increased interest rates by 10% out of the blue?

It was the craziest thing to come out of the Fed ever, and the financial world was in an uproar!

Wait, you don't remember this happening?

It was all over the media.

Petroleum prices went through the roof and milk was priced like gold.

You must have been sleeping!

Oh wait, we were just pulling your leg!

We just wanted to make sure you were still awake. Monetary policy would never dramatically change like that.

Most policy changes are made in small, incremental adjustments because the bigwigs at the central banks would have utter chaos on their hands if interest rates changed too radically.

Just the idea of something like happening would disrupt not only the individual trader, but the economy as a whole.

That's why we normally see interest rate changes of .25% to 1% at a time. Again, remember that central banks want price stability, not shock and awe.

Part of this stability comes with the amount of time needed to make these interest rate changes happen. It can take several months to even several years.

Just like traders who collect and study data to make their next move, central bankers do a similar job, but they have to focus their decision-making with the entire economy in mind, not just a single trade.

Interest rate hikes can be like stepping on the accelerator while interest rate cuts can be like hitting the brakes, but bear in mind that consumers and business react a little more slowly to these changes.

This lag time between the change in monetary policy and the actual effect on the economy can take one to two years.

Central banks like stability.

Economies like stability. Knowing that inflation targets exist will help a trader to understand why a central bank does what it does.