The monetary policy represents the tools of a central bank to keep inflation under control. That is if inflation is the only thing part of a central bank’s mandate.
Indeed, for most of the advanced economies, to keep inflation below or close to two percent represents a central bank’s task. Why is it that the same level fits various economies, from the United States to Japan, is still subject to debate.
The Federal Reserve of the United States has a dual mandate, though: it vows to maintain inflation below or close to two percent while creating jobs.
When compared with the inflation part of the mandate, there’s not a specific target on the jobs data. The Fed looks at full employment, but the wording has a different interpretation in economic terms than on plain English.
In any case, the monetary policy represents the set of tools a central bank applies to fulfill its mandate. For the ones involved in Forex trading, that’s all that matters, because currencies will shift aggressively when central banks “play” with these tools.
Implications of Monetary Policy for the Forex Market
Forex traders keep a close eye on the economic calendar. It shows the events for the period ahead and the possible implications for different currencies.
A close look at the economic calendar reveals when major central banks meet:
– Federal Reserve of the United States (FED) – every six weeks.
– European Central Bank (ECB) – every six weeks
– Bank of England (BOE) – monthly
– Bank of Canada (BOC) – monthly
– Bank of Japan (BOJ) – every six weeks
– Reserve Bank of New Zealand (RBNZ) – every six weeks
– Reserve Bank of Australia (RBA) – monthly
Therefore, out of the primary central banks in the world, only BOE and RBA meet monthly. For the Australian Forex traders, every Tuesday in a month becomes crucial as the Reserve Bank Board Meeting takes place.
For currency traders, these times during the trading year represent the moment the currencies move. If there’s a reason why the Forex market moves, it has much to do with the changes in monetary policy.
However, trading is a game of probabilities, with traders struggling to anticipate a future monetary policy change. For example, the Fed meets every six weeks.
But, in between two meetings, various economic releases come out. From jobs data (NFP, ADP, employment component in the ISM Non-Manufacturing and Manufacturing, and even the Initial and Continuing claims) to GDP and Retail Sales, traders are bombarded with financial data poised to move the market.
As such, everyone tries to interpret the data as best as possible, having one and only one idea in mind: what does it mean for the central bank and how will affect the monetary policy.
Central banks have various tools to use when setting the monetary policy. The most powerful of them all is the interest rate level. It represents the first option to fight inflation.
For a currency, the interest rate level is the one the moves it. Traders will react to higher interest rates with buying a currency, and selling when the central bank cuts them.
That’s the way it goes. However, sometimes, only changing the interest rate level isn’t enough.
When inflation falls below the zero level, as it happened in Japan and recently in the Eurozone too, central banks become “inventive.” They use unconventional measures of various types, having in mind one and one thing only: to stimulate the economy, or to stimulate commercial banks to lend money to people and businesses.
To sum up, Forex traders monitor the fundamental developments in an economy closely. For the well-prepared ones, it doesn’t matter what a central bank will do, as they will already be prepared for the moves.
Closely monitoring all the economic data in a month or during the six weeks period between two central bank meetings, will give traders an educated guess about what the outcome will be. As such, they’ll buy or sell a currency well before the central bank meeting takes place.