Monetary policy in forex trading

Central banks affect their domestic economy in several ways:

Through setting monetary policy. This entails encouraging the economy to grow through low interest rates, known as accommodative monetary policy, or slowing its growth and containing inflation through high interest rates, known as restrictive monetary policy.

•    Changes to the money supply. Increasing the amount of money circulating tends to raise prices and increase inflationary pressures, stimulating the economy. Decreasing the money supply inhibits price growth and retrains the economy.
•    Reserve requirements. Raising or lowering the amount of money a bank must keep in reserve alters the level of funds available for lending, which will also encourage or restrain economic growth.
•    Special measures, such as quantitative easing. By purchasing bonds of various descriptions, the central bank releases funds to the general market, again enabling economic growth.

Of particular importance is the role of inflation to the central banker. One theory of economic development holds that controlling inflationary pressures is key to managing the economic cycle, and that if inflation can be maintained with a certain range, the cycle will take care of itself. This has led to the establishment of inflation targets or target ranges by a number of central banks, generally 2.0% or between 2.0% to 3.0%, giving forex traders a key insight into the future of a nation’s monetary policy based upon its inflation path.

Internationally, money tends to flow across national boundaries away from lower interest rates, where large investors borrow money, and toward higher interest rates, where investors work their borrowed capital. This is called the carry trade, and its effect is easily visible on currency pair charts, as shown by the daily chart of the Australian dollar (monetary policy tightening from 3.0% to 4.5%) and the U.S. dollar (steady at 0.25%), below:

The difference between the two horizontal pink lines is roughly 3,400 pips, caused in large part by carry trade flows driving AUD higher.

Monetary policy must be long-range and forward-looking, with a window of roughly twelve to eighteen months ahead, according to estimates by the U.S. Federal Reserve. This fact has led international central bankers not to pre-commit their interest rate decisions, but to hint as to how they see the future path of monetary policy developing, as a contribution to financial and market stability.

This provides further tools for forex traders seeking to capitalise on interest rate movements:
•    Central bankers announce and typically discuss the decisions reached at rate-setting meetings, sometimes in great detail.
•    They release the meeting minutes, which offer insights into the decision-making process and the data considered.
•    They give public speeches, where they discuss their views of the economic state and future developments.

Note that carry trades are subject to market turmoil and fluctuations, as shown by the global financial crisis, visible on the chart above by the breathtaking plunge on the far left of the chart. As well, note the smaller one on the right, illustrating the influence of the European debt crisis.