Economic Cycles and Monetary Policy

Anyone on this forum kind enough to discuss, in a way that is relevant to a forex trader, economic cycles and the monetary policies likely to be implemented in each cycle? I haven't been following world economics long enough to see how reality works differently from theories and I want to see how mostly lagging indicators of an economy dictate future monetary policy. Your chief-of-a-central-bank like insight will be very helpful, not only to me surely but to most market participants on this forum as well.

The first priority for any central bank is to make sure inflation doesn't get out of control. If inflation threatens to rise to out-of-control levels, that trumps everything else and the central bank will tighten monetary policy (raise interest rates) as much as it needs to get inflation under control.

When inflation is under control, the central bank can loosen monetary policy (lower interest rates, pump cash into the economy) to boost growth and lower unemployment - but only as long as inflation stays low. It's that simple.

There are a million conspiracy theories here about evil central bankers telling lies, lining their pockets, looking after their friends, manipulating markets and secretly implementing various other nefarious schemes - it's all bullshit. Sure they try to talk their currencies down but if you read their mandate and follow the economic indicators they follow, you'll see they follow a very simple and predictable script.

Here is an example of a fundamental indicator I use to predict future monetary policy. (This one is slightly out of date, I haven't updated it for a few weeks)

As you can see inflation has fallen below the ECB's target of just below 2% and trending lower. Unemployment, while falling, is still high and economic growth is low.

These three indicators, coupled with some recent quotes I include with the indicator, tell me the ECB is almost certainly going to keep loosening monetary policy - lowering interest rates and injecting money via QE, until these trends change.

The answer of your question depends on which central you are referring to because not all central banks have the same goals. I'll try to answer your question by giving you an overview of how central banks with the dual mandate like the Fed or the central bank of Canada operate.

First you need to know what is the dual mandate, in other words, what is the main purpose of the central bank to exist. One of the mandate is for the economy to be strong enough to reach full employment. Around 5-7% unemployment rate would be an acceptable target for most CB. The other mandate is to reach price stability, i.e. control inflation. Most developed countries will have a target inflation around 2%. For that point it is important to know that central bank consider deflation to be one of the worst things that could ever happen so inflation really has to be kept around 2%, not higher and certainly not lower then 0.

Now, take each of those points individually and they are pretty easy to solve. Too much unemployment? drive the rates down and/or print money. The idea here is to make money cheap, so people get their money out of their bank accounts that gives no interest on savings and into the economy. That will create jobs because their is more spending. Usually this happens when there is a recession/crash where the markets are down and consumer confidence/activity is low, at that point the central bank will try to spark the market/economy/flow of money.

However, if money becomes too cheap, that credit is too accessible and people stop saving and just keep spending without being more productive then inflation will be just around the corner. The central bank at that point will raise interest rates so that the monetary mass will shrink a little bit i.e. so that money will stop cycling like crazy. With higher interest rates the consumer will be encouraged to save because his returns on deposited/invested money will be higher and he will also be deterred to borrow/spend because the cost of debt will rise. That happens when inflation is too high. In term of market cycle it usually (but not always) happens when markets are sky high and there is a perceived bubble in the markets.

Those two objectives are polar opposites and central banks will always be caught compromising one for the other and going back and forth shooting for an eluding equilibrium between the two targets.

Now you know that when umployement is high/the economy is going down the drain the CB will lower rates and print money but when things are going a little too fast the CB will raise rates trying to cool down the economy/markets. How does that help with trading FX you say? the answer lies in capital in/outflows.

The effects are two folds, short term and long term. In the short run if interest rates are raised it signals that things are going great in a certain part of the world but it also means that you will make more money holding the currency, Let say the US raises the rates .5% you now know that you will make more money on your deposit in US dollars and you also know that US bonds will yield higher returns. A lot of people will acquire us bonds/currency the USD will appreciate assuming that all else remains equals, this is capital inflows . The inverse is true in the short term for the lowering of rates.

For the long run the opposite is true. How come you ask? Remember that the aim of the CB is to cool down the economy and lower the inflation when they raise rates. When that happens, when people stop spending, unemployment starts to kick in coupled with the fact that export are down because the currency was too expensive to buy for other countries investors will start to think the music will soon stop. It becomes riskier to hold US bonds/treasuries. Capital outflows ensues. Keep in mind though that for this scenario we are thinking very long run, something like 3-5 years.

sorry for the long post. Hope it helps shed some lights on the basic mechanic of it all.

To understand how it translates in practice you just have to watch what is happening right now in the US. Unemployment is getting better, speculation of a raise in rates sent the USD through the roof, however inflation is still low so there is still some wiggle room to keep rates low for the FED. The markets are now trying assess how soon interest rates are going to be raised. If the consensus becomes sooner then later expect the USD to keep rising, if however poor employment data comes out it might change the expections for a early hike in rates and cause USD to stall/depreciate.