Central Banks and Monetary Policy: How Central Bankers Set Policy

• Central Banks look at a variety of economic data and projections before setting policy.
• These datapoints are then applied to the central bank’s operating framework in order to determine if a policy change is needed.
• To actually set policy, central banks turn to their implementation divisions, which transact in financial markets to enact policy.

HOW CENTRAL BANKS SET POLICY

Pipscollector.com - Central bank policy is an important driver of movements in financial markets. Central bank officials gather, project, and analyze economic data to determine the future path of the economy and its relation to the bank’s policy goals.

Challenges or deviations from the ideal path of the economy will often drive a central bank to policy action. However, the setting of a central bank policy is not as simple as issuing a press statement declaring a change in interest rates, an adjustment to asset purchases, or further supportive measures. Central bank policies must also be implemented through transactions in financial markets.

Central bank policies have a direct and oftentimes immediate impact on the FX markets. As central banks loosen or tighten policy, their respective currencies become more or less attractive to hold. Understanding the process by which central banks make such decisions is a valuable skill to any trader, as being able to predict what a central bank might do will give a greater depth of understanding to each key economic data release.

MANDATES AND PRICE STABILITY

While the US Federal Reserve is the most watched and most important of the central banks, it’s mandate exceeds that of the average central bank. The Federal Reserve is dually focused on maximum employment and price stability, while most central banks are focused exclusively on the price stability mandate. Price stability is best defined as low, stable, and predictable inflation. Most central bank’s target an inflation level of around 2%, which is viewed as a good indicator of strong and stable economic growth. When making monetary policy decisions, central banks must weight a variety of economic indicators, expectations, and conditions.

ECONOMIC DATA

Central banks parse the same economic data that FX traders and other market participants watch closely. Unemployment, housing, and inflation are some of the key data points central bankers track as they meet to discuss and set policy. These indicators are important to GDP and to identifying expanding or slowing trends in a large economy.

PROJECTIONS, ECONOMISTS

Beyond following the same economic data that market participants have access to, central banks employ hundreds of economists. These economists are specialized in a certain area of expertise and are often considered leaders in their field, making them the best choice to hold the responsibility of creating the projections that central banks will use to set policy. Economists create and model economic projections of the future path of the economy based on current data, expectations for the future, their knowledge of the subject area, and potential policy choices.

Central bankers use these models to anticipate where the economy is headed next and help evaluate the potential impact of their policy choices. Many central banks publish summaries of their economic and policy projections on a consistent basis, and these summaries are a valuable resource for traders looking to understand how an important driver of markets is viewing overall economic conditions.

FRAMEWORK

Once central banks have gathered the necessary amount of economic data and projections, they apply it to a framework in order to determine whether policy changes are needed. A central bank’s policy framework outlines its understanding of the relationship between key economic metrics and the central bank’s mandate, oftentimes how a variety of economic data points will weigh on inflation.

The ever-evolving world economy has led to continual evolution of central bank policy frameworks. Monetary policy setting was once based on simple rules and equations that dictated a proper level of interest rates given the relationship between inflation and employment. The world has since become much more complex, and central banks have moved away this simplistic, rules-based approach to policy.

The most important development, and the one with the largest implications for central bank policy, is the secular trend of low interest rates and low inflation in developed economies. Continued low interest rates have weakened the central bank’s ability to fight economic downturns through simple cuts in interest rates. Meanwhile, low inflation despite tight labor markets and low rates has meant that central banks have had to rethink and update their understanding of the relationship between employment and inflation.

With these shifting tides in mind, the Federal Reserve and the ECB have both conducted reviews of their monetary policy frameworks. While the ECB’s review and conclusions are still underway, the Federal Reserve announced its findings and its new policy framework in the late summer of 2020. In this announcement, Fed central bankers recognized that the relationship between inflation and employment had changed such that the economy can tolerate higher employment levels without inflation becoming a threat.

The Fed also changed its inflation policy from a symmetric 2% target to an average 2% target, meaning that Federal Reserve policy makers will now tolerate inflation higher than 2% so long as that higher inflation helps raise the average to 2%. In essence, this new framework communicates to the markets that the Fed will no longer be looking to tighten policy at the first signs of overheating but rather will allow policy to remain loose and the economy to heat up further.

For traders and market participants, understanding that higher inflation readouts and other strong economic data will not drive the Fed to preemptively tighten policy is an important departure from the framework that held true following the financial crisis. For central bank watchers and traders in general, the importance of understanding the central bank’s framework cannot be overstated. An understanding of the framework will make for more informed trades as you will be able to better predict the market’s expectation of the central bank following data releases.

Once the central bank reconciles new economic data and projections with its framework, it makes a decision. While such a decision was once as simple as raising or lowering rates, central bank toolkits have expanded dramatically since the financial crisis as central banks have played a larger role in supporting the financial system and the overall economy.

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