Forex Trading and Monetary Policy

The primary mandate for most of the major central banks around the world is to promote price stability and economic growth without excessive inflation, and this is accomplished with changes in monetary policy. There are a number of different factors that go into monetary policy decisions such as interest rates and reserve requirements for banks, but it has been proven over time that monetary policy decisions follow a cyclical pattern of expansion and contraction. If you can identify the signs of whether a certain country is biased towards expansionary or restrictive monetary policy, you can profit in the forex market by knowing which currencies to buy and sell.

The main issue that central banks focus on is inflation, because low inflation can stimulate stable investing, business, and commerce while high inflation can erode the value of assets and capital (something sometimes referred to as "confiscation by inflation"). So in order to make sure that inflation never gets too high and that the currency can remain stable, central banks such as the Federal Reserve, European Central Bank and the Bank of Japan will make monetary policy decisions that include changing the interest rates (called the "federal funds rate" in the United States), expanding or restricting the current monetary supply, and also increasing or decreasing the reserve requirements for banks which will affect the amount of new loans.

One of the factors that has the most significant effect on the foreign exchange market and the value of a currency is the current interest rate and especially any announcement of a change in the interest rate. Remember that monetary policy moves in cycles of expansionary policies and restrictive policies (which can also be referred to as the "boom and bust" cycle), so by looking at the current interest rate and where it is predicted to go you can determine whether the central bank behind that currency is practicing expansionary or restrictive policies, and hence you can know whether it is a good time to buy or sell that currency.

The term "interest rate" literally refers to the cost of money: Higher interest rates increase the cost of borrowing and lower interest rates reduce the cost of borrowing. Traditionally a central bank will lower interest rates to foster economic expansion, since this will reduce the cost of borrowing and likely increase investments and consumer spending. Increasing interest rates (also called contractionary monetary policy) will reduce consumer spending and investment spending which will lead to slower economic growth.

When you are able to identify the overall trend in monetary policy (expansion or contraction) then you can identify the overall trend of the currency and use this information in your trading. However, simply knowing the monetary policy cycle is not a trading signal that can tell you when to enter or exit the market, so in order to know when to trade you should look for economic announcements such as changing the current interest rate (usually in increments of 25 basis points or 0.25%) or look at the M1 and M2 monetary supply data from the Federal Reserve in order to see whether the current supply of money is growing or shrinking. Placing trades based on these announcements can be excellent forex day trading opportunities and can yield reliable buy and sell signals.