The following article was written by Shoaib Abedi, Director at ICM Capital.
Today, foreign exchange markets are severely impacted by the policies implemented from the central banks. These policies are aimed at meeting a number of key objectives such as achieving target growth rates, maintaining acceptable inflation levels, decreasing unemployment, and maintaining financial stability in a country.
Central banks adopt two essential policies to fulfill these objectives
Accommodative Monetary Policy: This is based on expanding the money supply in the markets and encouraging spending from customers and investors by lowering interest rates. If the lowered interest rates failed to accomplish that, a central bank resorts to quantitative easing by purchasing treasuries (bonds and debt instruments) to infuse capital into banks that loan it to individuals and businesses.
Central banks rely on accommodative monetary policies in cases of economic recessions, negative or below-target inflation or soaring unemployment. However, accommodative monetary policies are introduced only in emergency cases due to the fact that printing more money negatively impacts the monetary stability of a nation, and leads to a significant drop in currency value as a result of the increasing monetary offer.
Tight Policy: Contrary to the accommodative monetary policies, this policy makes money tight by increasing interest rates and curbing the money supply by selling more government bonds and debt instruments; consequently limiting the money supply available in the national banking system.
Central banks resort to the tight policy in case of a surge in growth rates in parallel with high inflation. In such a case, central banks work on reducing spending from customers and investors by lowering money supply to the economy and slowing down cash turnover in order to control the rocketing overall demand in the economy and hence, maintaining the required prices of goods and services.
How to predict upcoming policies of central banks?
As illustrated before, central banks assess the economic performance in a country and consequently adopt a monetary policy. Therefore, a central bank has to monitor a number of key economic data, the most essential of which are:
Gross Domestic Product: GDP is used to gauge the health of a country’s economy. It represents the total dollar value of all goods and services produced over a specific time period. Usually, GDP is expressed as a comparison to the previous quarter or year. Growth trends in GDP can be anticipated by monitoring the changes in its components, namely change in expenditure (measured by adding up the total retail sales and durable goods), investment expenditure (measured through the purchasing managers’ indices), governmental spending (extracted from government balance statements), and the gap between exports and imports.
A decline in economic growth may lead a central bank to adopting accommodative policies to stimulate growth.
Customer Price Index and Produce Price Index: These are the key indicators for measuring inflation. CPI in particular measures the price of goods and services over a period of time, usually a month or a year, in comparison to a previous benchmark or time period.
In case of rising inflation, central banks tend to adopt tight policies to maintain prices. However, in some cases and especially in a recession, a central bank may ignore inflation and adopt accommodative policies to counter recession. When it manages to instigate growth, a central bank reconsiders attempts to curb inflation.
Labor Market Data: Central banks pay close attention to this kind of data, especially in the USA where it is released on the first Friday of each month. It represents the health of the labour market and how it can create jobs and tackle unemployment.
If the labour market fails to create more jobs or alleviate unemployment, it is a sign that the economic growth may slow down. Hence, a central bank resorts to accommodative policies to promote production and consequently run the economic wheel.
This is essential to any country where free exchange markets are in place. Therefore, countries endeavour to maintain acceptable levels in balance of payments and public debt without losing their credit rating. In which case, there is a pressing need to balance between the monetary policies needed to stimulate the economy and full utilization against the purchasing power of, and confidence in, the national currency.
In conclusion, it is evident that understanding the economic data monitored by central banks is essential to anticipating the policies to be applied by central banks and how these may affect the forex market. Accommodative policies undermine the value of a country’s currency, while tight policies raise the value of currency.