Forex Market and Monetary Policy

The monetary policy of a country is decided by the central banks that are most often more or less independent agencies. The best known (ECB, FED, BOJ, BOE.) are independent but some are linked directly to the government as in China. There are three instruments of monetary policy used by the ECB:

Open market operations which are to influence the money supply in circulation and also financial assets

Standing facilities that match the credit policy (setting key interest rates)

Reserve requirements which are also designed to control the money supply by restricting credit expansion.

Open market operations

Open market operations play an important role in monetary policy for controlling interest rates, management of bank liquidity and signaling the stance of monetary policy. The open market operations are conducted at the initiative of the ECB, which chooses the instrument that has to be used for this operations. They can be executed by way of call for tenders, quick call of tenders or bilateral procedures. The open market operations of the Eurosystem can be divided into four categories:

Main refinancing operations consist of temporary grant transactions (in the form of repurchase agreements) aimed at providing liquidity on a regular basis with a weekly frequency and a maturity of two weeks. These operations are executed by the NCBs through standard tenders and according to a predefined schedule. The main refinancing operations play a pivotal role in pursuing the objectives for open market operations of the Eurosystem and provide the bulk of refinancing of the financial sector. Indeed, when an institution ‘puts in pension' titles, he temporarily ceded to the central bank which advances funds and 'takes in pension' titles. Bank liquidity will be increased. These refinancing operations can also be a longer term, with a monthly frequency and a maturity of three months to meet the financing needs of smaller structures.

Refinancing transactions may also be steadfast (that is to say definitive). This is the sale or purchase of securities, especially treasury bonds by the central bank on the interbank market. The aim is also to intervene on bank liquidity which will increase if the central bank buys securities and decrease it if the bank sells.

Fine-tuning operations are executed on an ad hoc basis to manage liquidity in the market and the driving of interest rates, particularly to mitigate the impact on interest rates of unexpected fluctuations in bank liquidity. The fine-tuning operations mainly take the form of temporary grant transactions, but may also include steadfast operations, currency swaps and the repurchase of cash deposits. Instruments and procedures used in the conduct of fine-tuning operations are adapted to the types of transactions and specific objectives.

Structural operations by issuing debt certificates and using a temporary grant operations or steadfast operations. These operations are executed whenever the ECB wishes to adjust the structural position of the Eurosystem on the financial sector (regularly or irregularly) without necessarily affecting the interest rates.

Standing facilities

Standing facilities provide or absorb liquidity overnight, signal the general stance of monetary policy and supervise market rates day by day.
They match with the credit policy (setting key interest rate). These rates are three:

The refinancing rate is used during open market operations. This rate determines the cost of credit that central banks provide to commercial banks in exchange for eligible assets. That cost will vary depending on the amount of credit that the central bank wants to distribute.

The marginal lending facility rate, counterparties may use to obtain central bank liquidity overnight against eligible assets. The interest rate of the marginal lending facility normally provides a ceiling on the daily interest rate market. This rate will be used only in emergencies because commercial banks will use only if the interbank market becomes illiquid (which was the case during the subprime crisis).

The deposit facility rate to make overnight deposits with central banks. The interest rate on the deposit facility normally provides a floor for overnight market interest rates. It corresponds to the rate paid on deposits by the central bank to commercial banks. This rate is lower than the rate of refinancing. Note that the Fed does not pay the deposits of commercial banks like the ECB.

Key rates are one of the most important regulating instruments of the economic activity for a central bank. They will enable to sustain the growth but also to fight against inflation.
Indeed, most interest rates are low, more a commercial bank can offer to its clients loans with low interest rates. Thus, the country's economy will become stronger by increasing liquidity in the financial circuit.

Conversely, an increase of key rates will aim to limit the demand of liquidity from banks. The aim is then usually to fight against inflation to avoid an overheating of the economy.

It should also be noted that interest rates directly affect the value of a currency. In fact, more a currency is remunerated (a high key rate), more the demand for that currency will be strong.

Reserve requirements

The reserves requirements are cash reserves that financial institutions must deposit on the central bank. The system of minimum reserves requirement is to stabilize the interest rate of the monetary market, to create (or to enlarge) a structural need of refinancing and to contribute, when needed, to the control of monetary growth. The amount of reserve requirement of each institution is determined based on a percentage of outstanding deposits.

For example, if a bank has 1 billion euros of deposits and the rate of reserve requirement is 10%, the commercial bank will deposit 100 million on the central bank.

Required reserves are remunerated at a rate corresponding to the average interest rate on the maintenance period, the main refinancing operations of the Eurosystem is 1% in 2010.

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