Monetary policy

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What is monetary policy?

Monetary policy (Monetary policy of the state is a set of measures taken by the Central Bank of the country by influencing the state of credit and money circulation. These measures serve as a way to regulate business activity, create favorable economic conditions for citizens to live and do business, strengthen the national currency exchange rate, maintain stability in the country and the stability of the balance of payments of the state.

What are the goals of monetary policy?

The goals of state monetary policy are:

Inflation regulation
Achieving full employment of the population
Regulating the growth rate of the economy
Timely response to cyclical fluctuations in the economy
Ensuring the sustainability and regulation of the balance of payments

What are the instruments of monetary policy?

The main instruments of monetary policy include:

Regulation of official reserve requirements

Regulation of official reserve requirements is the most powerful tool with which the Central Bank implements monetary regulation. The lending capacity of commercial banks is largely determined by the amount of reserves that commercial banks are required to keep in the accounts of the Central Bank. A commercial bank can extend credit only if it has sufficient funds in excess of this reserve. Accordingly, by reducing or increasing its reserve requirements, the CBR regulates the lending activities of commercial banks, thereby influencing the volume of money supply.

Transactions on open markets

Open market operations are another instrument of monetary regulation. The main method of using this instrument is the sale and purchase of government securities by the Central Bank. By purchasing securities on the open market, the Central Bank increases the volume of liquid funds of commercial banks, stimulating lending. The sale of securities leads to the opposite effect.

Another type of open market operation is currency interventions. The central bank of a state sells or buys on the open market a certain amount of currency from its foreign exchange reservesThereby weakening or strengthening the exchange rate of the national currency.

Regulation of interest (discount rate)

The interest rate or discount rate is the rate at which the Central Bank lends to commercial banks. By increasing or decreasing the level of the interest rate, the Central Bank regulates the cost of credit, thereby affecting the ability of commercial banks to lend to businesses and individuals. The change in the interest rate also affects the exchange rate of the national currency. An increase in the interest rate causes an inflow of funds into the national currency and is considered a risk-free investment by investors.

What types of monetary policy are there?

In the modern financial world it is customary to divide monetary policy into two types: soft ("dovish") and hard ("hawkish") monetary policy.

Soft monetary policy

A soft monetary policy is characterized by a gradual reduction of the interest rate by the Central Bank and keeping it at these levels for quite a long time, as well as the use of non-standard methods (series QE programs U.S. Federal Reserve, the LTRO program and quantitative easing by the ECB).

Soft monetary policy is aimed at stimulating the economy of the state by cheapening lending, fighting deflationary processes and accelerating inflation to certain target levels, but leads to a depreciation of the national currency. The followers of soft monetary policy are called "doves" and the policy, respectively, "dovish".

Tight monetary policy

Tight monetary policy is characterized by a consistent increase in the level of the discount rate by the Central Bank. Tight monetary policy is conducted by central banks of states with stable economies, as such a policy requires increased stability of the financial system of the state. An increase in interest rates also leads to an increase in the exchange rate of the national currency. Followers of tight monetary policy are called "hawks," and the policy, respectively, "hawkish.

How does monetary policy affect the exchange rate at ?

Classical fundamental analysis assumes the growth of the national currency exchange rate with an increase in the interest rate (risk-free investment - the higher the interest rate, the higher income the investor who invested money in the economy) and a decline in the national currency rate with a decrease in the discount rate (interest income from investments is minimal and of no interest to investors).

There is a concept of divergence (divergence) of monetary policies in the currency market. For example, in 2014, the U.S. Federal Reserve announced the beginning of the process of tightening monetary policy), and the ECB announced its intentions to soften its monetary policy. As a result, the EUR/USD currency pair declined throughout the second half of 2014.

Currency interventions by the Central Bank have a huge impact on the exchange rate of currency pairs. For example, in 2014 the Central Bank used interventions to curb the weakening of the ruble, and until the end of July 2015 the Bank of Russia was buying 200 million dollars daily to replenish its reserves, thereby curbing the strengthening of the ruble.

Widely known among traders and the SNB, which has regularly intervened to weaken the Swiss franc, which enjoys increased popularity as a shelter currencies. For example, the SNB's currency intervention on September 6, 2011 caused the USD/CHF to rise by almost 800 pips in a single trading day.

The exchange rate is also strongly influenced by the Central Bank's statement on the choice of one or another method of forming the national currency exchange rate and warnings about intentions, which are also called verbal interventions. For example, the announcement of the Bank of Russia about the refusal to regulate the ruble exchange rate was called "free floating" and caused the weakening of the Russian currency, the statement of the Federal Reserve System about the intention to raise the interest rate caused the strengthening of the dollar position, and The SNB's refusal to peg the Swiss franc to the euro The EUR/CHF exchange rate collapsed by more than 2,000 points in one day, causing bankruptcies of several brokers.

More about monetary policy and its instruments

Articles of the Master Class "Fundamental Analysis"