Monetary policy and the rate decision as a tradeable event
The most-watched event on any calendar, and the one most often misread — because what moves the price is not the decision but the part of it nobody had already bought.
Lesson 9 of 12.
What monetary policy is, and the three tools it uses
Monetary policy is a central bank changing how much money exists and what it costs, in order to hit a target — usually price stability, sometimes employment alongside it. Three tools do the work.
Open market operations. The central bank buys or sells government securities in the open market. Buying puts money into the banking system and pushes yields down; selling takes money out and pushes them up. This is the everyday tool, used continuously rather than announced.
The reserve requirement — how much banks must hold at the central bank rather than lend on. Lower it and the same deposits support more lending, which expands the money supply without the central bank creating anything. Raise it and lending contracts.
The discount rate — what the central bank charges banks to borrow from it directly. It sets the floor under what banks charge everybody else.
All three end in the same place: the quantity of money and its price. Which, from lesson seven, is the exchange rate.
The macro variables, and which currency they reach
Before the decisions themselves, it is worth having the chain in one place, because every release in lesson ten enters it somewhere.
- Growth rises -> the economy can bear higher rates -> the market brings rate expectations forward -> the currency strengthens.
- Inflation rises -> the central bank is more likely to raise -> the currency strengthens, unless inflation is high enough to look like loss of control, at which point the effect can reverse.
- Employment strengthens -> wages follow -> inflation follows -> the same chain again, which is why employment data moves currencies more than its subject suggests.
- The rate itself rises -> the differential against every other currency widens -> capital moves toward it. This is the shortest chain and the strongest.
The same cut, twice, with opposite results
Two Reserve Bank of Australia decisions, as the source prints them against AUD/USD.
The first: previous 1.25 per cent, forecast 1.00, actual 1.00. A quarter-point cut, exactly as expected. Everyone who wanted to be short the Australian dollar for it already was, so there was nothing left to reprice and the reaction was small.
The second: previous 0.75 per cent, forecast 0.75 — no change expected at all — actual 0.50. The same quarter-point cut, and this time nobody was positioned for it. The market had to reprice the whole move at once.
That is the lesson, and it generalises past rate decisions to everything else on the calendar: the size of the move is the size of the surprise, not the size of the change.
Reading a rate cycle rather than a rate decision
The source prints its American and Canadian examples as sequences rather than as single events, and that is the more useful way to read them.
The United States, against EUR/USD: 1.50 to 1.75, then 2.25 to 2.50 — a tightening cycle where each decision confirmed the direction of the last. Then, later in the same run of slides, 2.25 down to 2.00, and a move to 1.25 for which the source records no forecast at all.
Canada, against USD/CAD: 0.50 to 0.75, 1.25 to 1.50, 1.50 to 1.75 — three consecutive rises, each forecast correctly.
Two things fall out of reading them as cycles.
- A correctly forecast rise inside an established cycle is close to a non-event. The Canadian sequence is three of those in a row, and the currency was responding to the cycle, not to any one meeting in it.
- The tradeable moments in a cycle are its turns — the first move of a new direction, and the meeting where the language changes before the rate does. The middle of a cycle is where positions are held, not opened.
How to prepare for a decision
The routine is short, and it is mostly about establishing what is already priced.
- Check the market-implied odds before the meeting — CME Group publishes them for the Federal Reserve. A 95 per cent priced rise that arrives is not news, and planning a trade on it is planning to be right and unpaid.
- Decide in advance what would count as a surprise. If you have not written down what the forecast is, you cannot judge the release in the seconds after it lands.
- Read the statement for what changed, not for what it says. The wording is the guidance for the next meeting, and it moves markets more often than the rate does.
- Expect the first move to be wrong as often as not. Rate decisions routinely spike one way on the number and settle the other way on the language.
- Watch the yield curve into the meeting. From lesson eight, the bond market has usually made its mind up first, and a curve that disagrees with the consensus forecast is the most useful warning you will get.
What to take from this one
Three things:
- Monetary policy has three tools and they all end in the same place — how much money exists and what it costs.
- The move is the size of the surprise. Two identical cuts produced completely different charts because one was expected and one was not.
- Trade the turns of a cycle and the changes in language, not the middle. And check what is priced in before deciding anything is a surprise at all.
Next: the four numbers that move it
The four families of number that actually shift a price, what each measures, why the core version matters more, and what a miss looked like in each.