What is Monetary Policy?

Understanding Monetary Policy

Monetary policy is the central bank’s framework for achieving price stability and sustainable employment. Tools include the policy rate, balance‑sheet operations (QE/QT), and forward guidance. For FX, policy expectations are the primary driver of cross‑country yield differentials and currency trends.

Transmission Channels

• Interest‑rate channel: Higher rates cool demand and lift currency via yield appeal.
• Expectations channel: Guidance and dots shape the path of future policy.
• Balance sheet: Asset purchases or runoff alter liquidity and term premia.
• FX passthrough: Currency moves feed back into imported inflation and growth.

Global Policy Cycles

Policy cycles rarely align. When one region tightens as another pauses, FX trends emerge. Traders compare terminal‑rate expectations, start dates for cuts, and the pace of balance‑sheet changes to position for divergence. Watch meeting minutes and speech calendars between decisions for incremental shifts.

Trading Implications

• Pre‑build hawkish/dovish scenarios for each meeting and plan trade triggers.
• Let front‑end yields confirm; if they fade, fade the currency move.
• Respect communication risk—press conferences often drive the second leg.
• Monitor fiscal interaction; loose fiscal plus tight money can heighten volatility.

Lags and Nonlinearity

Policy acts with long and variable lags. Don’t expect instant feedback in inflation or growth. Late‑cycle hikes can invert curves and tighten credit despite little movement in unemployment—FX responds to these forward signals.

Cross‑asset confirmation improves odds. A hawkish surprise should lift front‑end yields, flatten curves, and support the currency; a dovish pivot should do the opposite. If FX diverges from rates, suspect positioning or a transient liquidity effect.

Balance‑sheet policy matters at the margin. Quantitative tightening withdraws liquidity and can pressure risk assets even without hikes; easing can cushion markets. Track runoff caps, reinvestment policies, and the mix of assets being reduced—these details influence term premia and, by extension, currency demand for carry.