Tight vs loose monetary policy: How to trade central bank shifts

Monetary policy refers to the activity of central banks, such as the Federal Reserve (Fed) in the US and the Bank of England (BOE) in the UK, in managing the national economy. Central bank policies affect money supply and contribute towards achieving macroeconomic objectives, such as limiting inflation and encouraging economic growth.

These macroeconomic objectives and indicators have significant bearing on the performance of all sorts of securities. Markets often respond as soon as a policy is announced, or even suggested, so investors need to keep a close eye on central bank messaging.

The outcomes are often discussed by the Federal Open Market Committee (FOMC)​, which is the monetary policy-making branch of the Fed.

Some of the tools central banks have at their disposal include:

With tight (or contractionary) monetary policy, central banks adopt one or more measures aimed at slowing the money supply, usually in order to limit inflation. These measures can include raising interest rates and reserve requirements for banks, which discourages them from borrowing and incentivises them to lend less. This limits the supply of credit to individuals and businesses in the wider economy, meaning that businesses will invest less in equipment and hiring new staff.

This will typically reduce the price of securities, such as stocks, because investors will be less optimistic about companies’ future expansion prospects. There is, however, often a long lag time between contractionary policies being implemented and equities peaking. High interest rates have a strong negative impact on bond prices, as investors seek higher yields. Property and commodity markets tend to suffer under tight monetary policies, but a central bank’s national currency usually rises.

Loose (or expansionary) monetary policy seeks to stimulate economic activity in order to deter economic downturns, such as recessions. Conventionally, it involves reducing factors such as short-term interest rates and reserve requirements for banks, encouraging bank lending to consumers and businesses. However, in exceptional circumstances it can also involve measures like quantitative easing, where new money is effectively created by the central bank and injected into the financial system by purchasing government bonds​.

The extra cash in the system increases consumers’ spending and businesses’ expansion, as loans are cheaper. This has a beneficial impact on stock markets, as well as property markets (given the greater availability of mortgages) and commodities (as raw materials are in greater demand). Low interest rates decrease bond yields, discouraging cash and savings. Though the relationship is complex, national currencies will typically depreciate relative to their peers when the central bank adopts a looser approach.

Monetary doves prioritise minimising unemployment and related indicators, therefore, favouring loose approaches. A dovish stance believes that stimulating economic growth has few negative effects.

Hawks, by contrast, believe monetary policy should focus on minimising economic indicators​ such as inflation, and therefore advocate restrictive policies. A hawkish view sees the risk of inflation as a threat to the overall economy, and believes stability is gained by keeping economies below maximum employment rates.

Many economists, for example Alan Greenspan, former chair of the Fed, have alternated between hawkish and dovish views. Investors can capitalise on these changes in central bank monetary policy by buying securities expected to benefit from new policies early.

Bonds and equities tend to be cheaper at the end of a period of contractionary policy. When a central bank announces a shift to more expansionary measures, the securities are highly likely to rise in the future. In this situation, investors may choose to take a long position in these asset classes.

The same holds true in reverse: investors or traders can go short on an equity if the expectation is that its value will fall, or invest in the national currency (i.e. increase savings), when central banks announce a policy of raising interest rates.

By keeping a close eye on the tone and policy changes of central banks, a trader can try to make timely investments using the following guidelines: