Monetary Policy and How It Affects a Currency’s Value

 

Hello there, this is tradingpedia.com and during this video we will discuss about monetary policy and how it affects the value of a currency. To start with, imagine that all the currency pairs seen here are called exchange rates, or quotes, and they reflect the value of a currency in terms of another one.

For instance, the EURUSD at 1.1901 here shows how much one dollar is worth in terms of EUR, or the other way around. To understand how an exchange rate moves, we must understand what moves a currency and monetary policy is the right thing to interpret.

Monetary Policy

Monetary policy is set by central banks. Imagine that this is the world with the U.S. here, Europe, Australia, Japan, etc. Each region or country has one currency. The G10 currencies are the most important ones in the sense that when they move against the world’s reserve currency, the USD, then you will see a shift in the monetary policy.

Monetary policy refers to each central bank (e.g. Federal Reserve of the United States, ECB in the EURUSD) having a mandate, price stability, which refers to the 2% inflation level. For example, the ECB has a mandate to keep inflation below but close to 2%. Why 2% and not zero?

Inflation Targeting

It is viewed by economists that 2% is above the zero level, so to avoid deflation, but not high enough to threaten the value of money. The inflation target principle was invented the first time by the Reserve Bank of New Zealand some decades ago and it was quickly adopted by other central banks. What central banks in normal times raise the interest rates, they do that because inflation is on the rise. Higher inflation leads to higher interest rates, and that is positive for a currency. Lower inflation leads to lower interest rates, the central banks change the tone from hawkish to neutral and dovish and that will hurt the currency.

The lower inflation goes, the easier the monetary policy becomes. Depending on the crisis and the economic impact, how to economy reacts and how the business cycle evolves, the central bank will do more.

Quantitative Easing Program

The 2008 and 2009 Great Financial Crisis brought innovations to monetary policy. The Fed introduced a new tool called quantitative easing. The Fed bought bonds issued by the U.S. government with the intention of creating digital money and that is easing, in an attempt to debase the currency as inflation was non-existence. To create inflation, the Fed started the QE program.

QE was tested in Japan as well, and the size was bigger than the one in the U.S. After that experiment, the economy in the U.S. recovered, the inflation picked-up, and the EURUSD, for instance, reacted. The Fed raised rates from 0 to over 2%, and the EURUSD declined because the interest rates in the euro area were mostly negative. The ECB sets three interest rates and one of them, the deposit facility, was still below zero and the other ones, for example the marginal lending facility was barely above zero.

Interest Rate

So the interest rate differential set by the two entities, the ECB in Europe and the Fed in the United States, favored a higher USD against the EUR. The USD appreciated not only against the EUR, but against the entire FX dashboard, because the federal funds rate was the higher in the developed world. So the interest rate differential is all that matters when it comes to interpret monetary policy and the value of a currency.

Besides interest rates, central banks also use unconventional monetary policy tools, like the QE, or TLTROs in Europe (cheap loans for companies to take and they will repay them at very low rates) and other decisions to affect the value of money.

The sum of monetary policy decisions in various parts of the world is responsible for the FX dashboard’s volatility. For example, during this pandemic, the Fed eased the policy just like other central banks, like the ECB. So why did the EURUSD moved to the upside? The answer comes from the fiscal stimulus, as the one in the U.S. outpaced anything seen in the world, so the USD declined significantly as the difference in the easing in various parts of the world favors a lower USD.

As a consequence, the EURUSD is at highs, GBPUSD recovered to 1.31 from below 1.20, AUDUSD did the same, etc., only because monetary and fiscal policy packages point to more easing in the United States.

Conclusion

To sum up, monetary policy in normal times is all about the interest rates. When a crisis comes, central banks are the most innovative ones in the world and new tools come out to fight the crisis and during economic expansion times they are fine-tuned and become regular tools in the toolbox. It is important to remember that the currency pair or the exchange rate moves based on the interest rate differential set by the two central banks. If this is the EURUSD, it will move based on the differential between the USD and the EUR. Or, the EURJPY will move based on the interest rate differential between the Euro area and Japan.

Thank you for being here, bye bye.