When reading economic news, you will certainly find terms such as reverse requirements, open market operations and others. These terms relate to the monetary policy of a country’s central bank which will affect the forex market movements. As a forex trader, we need to know what monetary policies are often carried out by the central bank.
The main objective of monetary policy is to fulfill the central bank’s duty to maintain the stability of currency exchange rates. Therefore, monetary policy taken by the central bank will ultimately affect currency exchange rates.
In determining a policy, the central banks of advanced industrial countries do not depend on the central government (independent). This independence can be witnessed at leading central banks such as the Federal Reserve (the Fed), the Bank of England (BoE), the European Central Bank (ECB) and the Bank of Japan (BoJ). Even so, there is also a central bank that is still associated with the central government, for example the People’s Bank of China (PBoC).
Determination of the central bank’s monetary policy uses certain instruments. In this article, we will exemplify three instruments used by the European Central Bank (ECB), namely:
Open market operations that will affect the money supply and financial assets.
Open market operations are ways to regulate money circulating in the community by selling or buying government bonds or government securities. If you want to increase the amount of money in circulation, the government will buy securities. Conversely, if the government wants to reduce the money supply, the government will sell government securities to the public.
The sale and purchase process is carried out openly through auctions attended by securities agents, such as bond sale auctions that are often carried out by the governments of Germany, Spain, France and Italy.
In the forex market, the practice of buying securities including loose monetary policies can have an effect on the weakening of the Euro exchange rate. Conversely, termination of purchases of securities or even sales, including tight monetary policies that can boost the Euro exchange rate.
Standing facility which basically concerns interest rate adjustments.
The central bank’s monetary policy instrument regulates the provision of funds from the central bank to commercial banks, namely facilities for banks experiencing liquidity difficulties. In addition, it also includes the placement of funds from commercial banks in the central bank, namely facilities for banks that have excess liquidity.
In practice, to encourage public banks to save or withdraw funds at the central bank, the central bank will change interest rates. Or in other words, regulating the amount of money in circulation can be done by playing the central bank interest rate imposed on commercial banks. To increase the money supply, the central bank will reduce interest rates; while to reduce the money supply, the central bank will raise interest rates.
The effect of this central bank monetary policy could be two. If the central bank raises interest rates, the exchange rate can strengthen. Conversely, if the central bank reduces interest rates, then the exchange rate can weaken.
Reverse requirements used to regulate the money supply by limiting credit expansion.
This monetary policy instrument regulates the money supply by playing with the amount of banking reserve funds that must be deposited with the central bank. To increase the money supply, the central bank reduces the amount of minimum mandatory reserves. Conversely, to reduce the money supply, the central bank will increase the minimum required reserve. This is also intended to maintain stability in interest rates and bank credit expansion.
For example, if a bank has a deposit of 1 billion Euros and a minimum reserve of 1%, then the bank must place a minimum of 10 million Euros at the ECB. If the reserve must be increased to 2%, then the bank’s credit distribution will decrease; on the contrary if the mandatory reserve is reduced to 0.5%, then the bank’s credit distribution will increase.