Influence of monetary policy on exchange rates

Traders who start learning fundamental analysis need to know that the key role in exchange rate formation at Forex is played by central banks.    Although they don’t buy or sell currencies, their decisions allow investors, including big banks and hedge funds, to define in which direction and how fast the rates will be moving. If they know the answer to this question, they can invest money in safe-heaven or risky assets and form an investment portfolio in a way that is likely to be the most productive. 

As the lion’s share of Forex trading is connected with dollar pairs, it’s understandable why markets are so reactive to the Fed’s statements, accompanying statements, and FOMC minutes which are often the key weekly events. Important players try to get into the brain of the world’s leading bank to understand where they’d better invest their money. In this respect, the Fed’s attempt to change approaches to inflation targeting (management) must attract great attention of both Forex sharks and beginners in fundamental analysis. 

Any central bank’s activity is aimed at assuring price stability. Inflation of 2% is considered as optimal for economy.   A faster price growth lowers the population’s purchasing power whereas a slower growth increases savings and limits GDP potential growth.   To reach the target of 2%, central banks either stimulate economy by lowering rates, through QE, LTRO, and other programs, or, on the contrary, by tightening monetary policy. 

As a rule, when economy is on the top of its development, strong domestic demand pushes inflation above 2%. It makes a central bank raise rates, increases borrowing costs and contributes to the correction of stock indexes. Finally, it may lead to recession. That’s why these are central banks that are considered to form  an economic cycle. The best confirmation is a fall of the yield curve to the red zone. This indicator has anticipated recessions many times and its dynamics somewhat reflect the Fed’s point of view.  The difference between 10-year and 2-year US  bond yields is one pace away from inversion, and it calls on the Fed to be careful.  

Yield curve dynamics

Source: Bloomberg.

Jerome Powell and his team’s intention to revise inflation management approaches is connected with a desire to extend good times for the US economy, i.e. the current economic cycle. The Central Bank admits 2% inflation provided that GDP is growing steadily. On the contrary, Personal consumption expenditure may be below the target under week dynamics. In other words, the Fed is ready to target the average inflation value and not its specific value. 

US inflation dynamics

Source: Wall Street Journal.

It will help avoid raising federal funds rates if PCE rises to 2.5%-3% as the average value will be lower in the economic cycle. At the same time, there’s a lower risk of Fed’s pushing the US economy to recession.                                         

If Washington adopts this inflation management approach, the completion of the current normalization cycle will put an end to the greenback’s growth. Monetary restriction is the main trump of any currency. Future dynamics of dollar pairs will depend on decisions taken by the Fed’s competitors.    

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Price chart of EURUSD in real time mode

Will the Fed change game rules?

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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