Econ Grapher

Monetary Policy

What is Monetary Policy?
Monetary policy is basically what the central bank of an economy does. It consists of managing the money supply and interest rates. It often extends to managing the stability of the financial markets, banking system, and payment system, and often central banks will be mandated with banking supervision. Indeed central banks have a particularly close relationship with commercial banks, in terms of being the lender of last resort, supervision functions, and of course the fact that many of the tools of monetary policy (see below) are implemented via the banking system. The goal of monetary policy is generally to maximize growth, employment, and price stability (low inflation). Most monetary authorities have price stability as their core mandate, but in due reference to economic growth and employment. Thus much of the monetary policy actions, decisions and observations are in relation to these factors.

How does it relate to Markets?
Monetary policy decisions and actions are among the most closely watched events in the markets. Interest rate decisions will often move markets noticeably, and because central banks must have a keen sense of what is going on in the economy in order to do their jobs, the statements and press releases which accompany decisions and announcements are often rich with information and insights on the status of the economy. So interest rate announcements can have varying effects, e.g. an increase in rates will lead to lower valuations (because it means using a higher discount rate), it also signals that inflation is probably high or expected to be high (which is also bad for stocks i.e. lower expected future cash flows), however it is also a vote of confidence in the level of economic activity (i.e. that the economy can withstand an increase in the interest rate), however it also means that investors may be enticed out of risky assets by low interest rates. 

So in general rising interest rates are bad for the stock market (and bond market, as rising interest rates implied falling bond prices). In terms of Forex markets though, it's somewhat different, and a bit more complex, in the short term relative interest rates will create interest differentials e.g. NZ rate is higher than US rate, which will see the "carry trade" take-off which will push up the NZD against the USD. So there's a number of issues to consider when gauging the possible impact on markets, and you need to take into account the full spectrum of factors e.g. state of the economy, outlook for the economy, market expectations, security specific factors, etc.

Tools of Monetary Policy: Interest Rates, Reserve Rates, and Others
In brief, the main tool of a central bank is its official interest rate. Indeed this is typically the most watched action of central banks (changes to the interest rate). Other tools include the required reserve ratio that banks are required to conform to i.e. how much money the banks must hold on reserve in relation to loans made. Then there are a range of other non-conventional measures that can be taken, as illustrated by the 2008 financial crisis where many central banks dropped their interest rate to near zero, and then began programs of bond purchases, quantitative easing, currency/liquidity swaps with other central banks, and other financial market intervention designed to maintain the functioning of markets and bring market interest rates in line with policy rates.

Mandate and Purpose of Monetary Policy
The specific mandate that a central bank has in implementing monetary policy will differ by country, but most include price stability (which is often translated into explicit inflation targets e.g. 2-3% in the US, 1-3% in New Zealand, 2% in the EU, 2% in the UK, etc). As noted before the mandate often also includes economic growth and full employment. However the issue is that there tends to be conflict between these outcomes. For example high economic growth often leads to inflation, likewise full employment will tend to lead to price rises as well, and on the flipside, to try and contain inflation e.g. by increasing interest rates, which has the effect of slowing the economy. As a general rule, having an interest rate excessively low for an extended period of time will tend to lead to excessive risk taking, as was one of the contributors to the 2008 financial crisis. 

Expansionary or Contractionary? Loose or Tight?
These terms are used to describe the current settings of monetary policy. If interest rates are low, reserve requirements are low, liquidity provision, and money growth are high, then monetary policy is said to be loose or expansionary or accommodative. In other words loose monetary policy is used to try and stimulate the economy, because growth or employment are too low, and/or because inflation is below target, or at risk of falling into deflation. Tight or contractionary policy refers to attempting to constrict or reduce the money supply or contract or restrict money supply growth, with the objective of slowing the economy, slowing spending, and of course, maintaining price stability.

Sources and further reading:
Library of Economics and Liberty (highly recommended)
US Federal Reserve - Monetary Policy
European Central Bank - Monetary Policy
Bank of England - Monetary Policy Framework
Wikipedia - Monetary Policy

Graph Library:
Metric - Monetary Policy

Original Source: http://www.econgrapher.com/encyclopedia-monetarypolicy.html

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