Central banks and monetary policy go hand-in-hand, so you can’t talk about one without talking about the other.
While some of these mandates and goals are very similar between the world’s central banks, each has its own unique set of goals brought on by their distinctive economies.
Ultimately, monetary policy boils down to promoting and maintaining price stability and economic growth.
To achieve their goals, central banks use monetary policy mainly to control the following:
- the interest rates tied to the cost of money
- the rise in inflation
- the money supply
- reserve requirements over banks (the portion of depositors’ balances that commercial banks must have on hand for withdrawals)
- lending reserves to commercial banks (via the discount window)
- interest on reserve balances that commercial banks hold (IORB rate)
Types of Monetary Policy
Monetary policy can be referred to in a couple of different ways.
Contractionary or restrictive monetary policy takes place if it reduces the size of the money supply.
It can also occur with the raising of interest rates.
The idea here is to slow economic growth with high-interest rates.
Borrowing money becomes harder and more expensive, which reduces spending and investment by both consumers and businesses.
Expansionary Monetary Policy
Expansionary monetary policy, on the other hand, expands or increases the money supply, or decreases the interest rate.
The cost of borrowing money goes down in hopes that spending and investment will go up.
Accommodative Monetary Policy
Accommodative monetary policy aims to create economic growth by lowering the interest rate, whereas tight monetary policy is set to reduce inflation or restrain economic growth by raising interest rates.
Neutral Monetary Policy
Finally, a neutral monetary policy intends to neither create growth nor fight inflation.
The important thing to remember about inflation is that central banks usually have an inflation target in mind, say 2%.
They might not come out and say it specifically, but their monetary policies all operate and focus on reaching this comfort zone.
They know that some inflation is a good thing, but out-of-control inflation can remove the confidence people have in their economy, their jobs, and ultimately, their money.
By having target inflation levels, central banks help market participants better understand how they (the central bankers) will deal with the current economic landscape.
Let’s take a look at an example.
Back in January of 2010, inflation in the U.K. shot up to 3.5% from 2.9% in just one month. With a target inflation rate of 2%, the new 3.5% rate was well above the Bank of England’s comfort zone.
Mervyn King, the then-governor of the BOE, followed up the report by reassuring people that temporary factors caused the sudden jump, and that the current inflation rate would fall in the near term with minimal action from the BOE.
Whether or not his statements turned out to be true is not the point here.
We just want to show that the market is in a better place when it knows why the central bank does or doesn’t do something in relation to its target interest rate.
Simply put, traders like stability.
Central banks like stability.
Economies like stability.
Knowing that inflation targets exist will help a trader to understand why a central bank does what it does.
