Monetary policy and the role of central banks

Central Banks

Central banks are national institutions which control the commercial banking field, interest rates, money in circulation and currencies. The idea of central banking was developed long ago, with the first institutions of that type opened in China about a millennium ago, together with the first-time issuance of paper money. In the centuries of its existence, the central bank institution has evolved and improved, to reach the present stage of contemporary banking systems.

Examples of central banks today include: the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of England (BOE), the Bank of Canada,the Reserve Bank of Australia (RBA) and others. The influence exerted by a central bank can spread over one country, like the RBA, or it can represent the policy of a group or region of countries, an example being the ECB. The discussion of the US Federal Reserve and the delving into its policy decisions will help to show the impact that central banking exerts on society.

The US Fed

The Fed came into existence in 1913, as the Congress was determined to provide the US with a monetary system which was stable and safe. Nowadays the Fed operates by carrying out monetary policy; the supervision and regulation of banks are also among its main mandates.

Bank Regulations

The Federal Reserve was established mainly with the purpose of assuaging banking panics in the country, like the one in 1907, when on the New York Stock Exchange a brutal 50% decline in stocks relative to their 1906 highs took place. Ultimately a number of banks and businesses had to close or to declare bankruptcy. US citizens were pestered by the apprehension of non-safety for their funds in local banks, and they rushed in panic to withdraw them, which in turn led to hefty capital shortages.

One of the main goals of the Federal Reserve as an institution is to prevent similar crises. It offers a system for handling short-term needs of local banks, in the event that such massive withdrawal of deposits occurs or if regional emergencies arise. In such cases the Fed would lend funds to banks, at a nominal charge, also known as the discount rate. After the situation has been curbed, banks can repay their obligations to the Federal Reserve. That is a policy belonging to the bundle of tools the Fed deploys to ensure the solvency for bank depositories.

Monetary Policy Explained

Monetary policy also belongs to the Fed’s tools. The term monetary policydenotes the activities undertaken by the Fed to achieve control over the US monetary supply inside the country. The Fed can take decisions depending on the economy state, to adopt an expansionary policy or a contractionary policy, whereby money supply is influenced via two methods.

In periods of economic slowdown, it is the Fed frequent choice to consider adopting an expansionary policy. To begin with, the monetary base is expanded and interest rates are decreased. The essence of the expansionary policy is that money is more widely available to both banks and businesses, so that growth and development can be boosted. The results targeted are increase in the GDP and shrinking of the unemployment rate.

Sometimes, following a period of rapid economic expansion the economy heats up. Before that happens or in the worst case scenario when this happens, the Fed proceeds to the adoption of a contractionary policy. In doing that, the central bank shrinks the monetary base and hikes the main interest rates. As a result, excess capital becomes scarcer, and a higher premium is imposed on lending. Owing to the smaller scale circulation of capital, the economy is bound to commence a slowdown. During the period of contraction the GDP is expected to decrease and the unemployment rate to rise.

Impact on Currency Rates

The Fed decisions control money supply and demand, regulate interest rates, and thus directly impact the USD strength or weakness. When there is expansionary policy in action, there is a boost in the monetary base, and a diminishment in interest rates. The market and banks are provided with more money than the demanded amounts, so its value soars. The oversupply of money sends a deluge of cheap dollars onto the market. As a result the currency depreciates. Changing the main interest rate leads to the same outcome via the market transmission mechanism: as rates decrease, borrowing funds becomes easier to get, and the currency value slumps.

When the Fed opts for a contractionary policy, the opposite is observed. The draining of funds on the open market leads to capital scarcity. The consequences involve value soaring of the funds in circulation. The interest rates rise follows the same pattern in effect. With higher rates, funds become more expensive to borrow, so their availability diminishes owing to the barrier imposed to lending. With capital scarcity in place, currency appreciationcan be expected again.

The Significance for Traders

For currency traders it is of great importance to track the policy cycle of central banks because that is crucial for their forex speculations.The European Central Bank is one recent case in point with regard to expansionary measures. The European Central Bank has reduced interest rates, from a peak of 4.25% in 2008, down to 0.15%. The deposit rate is already into negative territory. That is combined with an expansion of the monetary base owing to extension and refinancing of new debt. As a result of this, the euro has started to depreciate with respect to most of the major currency pairs.

This tendency can be most notably seen by observing the euro performance against high yielding currencies, such as the New Zealand dollar and the Australian dollar. For less than a year, the EUR/NZD has dropped with about 15 figures (1500 pips) since late August 2013. On the EUR/AUD front, we see a decline of more than 14 figures (1400 pips) since late January 2014!

The developments described above are expected to continue. The interest rate differentials between the euro on one side, and the AUD and NZD on the other, are expected to drive EUR/NZD and EUR/AUD further south. Forex traders could try to take advantage of these trends. What makes the situation even better, overnight swaps for holding short EUR/NZD and EUR/AUD positions are also favoring such strategy. But that is a different topic reviewed in the article, “Rollover costs and Carry Trade”.