The True Impact of Monetary Policy on the Forex Market

Monetary policy is perhaps the most pivotal driver impacting foreign exchange (forex) because it influences the currencies in circulation. Following the Federal Reserve’s announcement of hike rates to tame inflation, the U.S. dollar strengthened significantly compared to other currencies. The Fed hiked the benchmark federal funds rate seven times last year, causing the greenback to register its best year since 2016. 

However, the trends have changed this year, as the Fed has signaled lower rate hikes. The U.S. dollar index slumped last week as the central bank raised the interest rate by 25 basis points. 

Let’s take a closer look at the correlation between monetary policy and the forex market to better understand exchange rate fluctuations. 

Monetary policy is one of the most important tools used by central banks worldwide to regulate the total currencies in circulation. Controlling the aggregate money supply has implications for a nation’s economic growth, employment, inflation level and forex markets. The U.S. central bank controls the total amount of U.S. dollars in circulation globally at any given point in time, while the European Central Bank (ECB) and Bank of England control the quantity of euro (EUR) and Great British Pound (GBP) disseminated worldwide. 

A central bank has several tools at its disposal, allowing it to properly regulate an economy’s money supply. The Federal funds rate, which is the rate at which banks can lend and borrow excess funds overnight, is often the most common parameter by central banks globally. Other policy tools include open market operations, under which the Fed buys and sells government bonds (Treasuries), and discount window and rate, which is the interest rate charged by the Fed on loans to commercial banks. 

Central banks use monetary policy tools to increase, decrease or maintain a currency’s total supply to meet the economic goals set forth or address macroeconomic headwinds. Let’s look at the four types of monetary policies. 

This policy is implemented when a central bank aims to reduce a nation’s total currency in circulation. Raising the benchmark interest rate is a standard technique implemented for restrictive monetary policies. This process raises the average borrowing costs in a country, thereby encouraging businesses and investors to scale down their operations. Other commonly used restrictive monetary policy tools are raising the discount rate and selling government bonds in the open market. 

The Fed has raised the federal funds rate eight times since last year, while the ECB increased its interest rate five times since 2022. 

Under expansionary policies, central banks boost the total money supply to promote economic growth. Borrowing becomes cheaper under this policy, encouraging people to spend more. As a result, the aggregate demand rises, prompting a rise in total production and gross domestic product (GDP). Banks lower interest rates and discount rates and buy government bonds and other debt to improve and raise the total money supply. 

During the initial wave of COVID-19, central banks around the world adopted an expansionary monetary policy to mitigate the impact of the global lockdown. The Fed lowered its benchmark rate to near-zero levels during the first quarter of 2020 and also implemented a significant quantitative easing strategy.

This is when central banks raise the total money supply in economies to prevent stagnation for fuel economic growth. It is similar to expansionary monetary policy, as banks use similar tools to effectuate an accommodative policy. 

The Fed implemented an accommodative policy to bring the U.S. economy out of recession in 2008 when the unemployment rate hovered at 6.5%, while inflation fell below 2% and was projected to decline further. 

When an economy runs at the perfect pace, a central bank pursues a neutral monetary policy to maintain the equilibrium. It is imperative that such a policy is only used when the “economic conditions are just right,” as stated by Janet Yellen, the Secretary of the U.S. Department of Treasury. 

Theoretically, a nation with the highest possible GDP growth rate, inflation below the predetermined target and operating at the natural rate of unemployment is considered to be in equilibrium, allowing for the utilization of a neutral monetary policy. 

Typically, when a central bank implements a contractionary monetary policy, the respective currency strengthens, causing associated exchange rates to rise. Illustrating with an example, assume 1 USD = 100 JPY (Japanese yen). If the U.S. dollar appreciates in value, then 1 unit of the greenback can buy even more units of JPY. Thus, the new forex rate can be 1 USD = 103 JPY. 

However, if the markets expect contractionary policies to slow down in the upcoming months or have already priced in the impact, the forex rate might fall. Recently, as the Fed hiked rates by only 25 basis points earlier this month and signaled tamer hikes ahead, the US dollar index declined marginally year-to-date. 

Monetary policy is the most important economic factor influencing forex rates. While it is difficult to know the exact monetary policy tools a central bank might use to regulate a currency, economists often release predictions regarding the next plausible move by the central bank. Committee heads release their own statements and projections. The Federal Open Market Committee members and regional Fed chairpersons also announce their official projections, which are combined to create a Fed Dot Plot. 

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