Lesson 3: Hawkish Vs. Dovish Monetary Policy

You know by now that central banks are immensely influential in the forex market. One of the reasons for a central bank’s authority in the forex market is because of the monetary policy tools it wields. 

These tools help central banks control the relative value of their countries’ currencies. This means they can influence their currencies to increase or decrease in value. 

Monetary policies are a major factor in fundamental analysis. It is something that virtually all traders anticipate and pay attention to. 

In this lesson, you’ll learn more about monetary policies, specifically the differences between a dovish and hawkish monetary policy. 

Lesson Highlights 

• Central banks control the relative value of their countries’ currency value using monetary policy tools. 
• Central banks have various monetary policy instruments at their disposal, such as interest rates, open market operations, and currency interventions. 
• A central bank can increase interest rates to combat rising inflation. 
• Open market operations allow central banks to increase or decrease the amount of circulating domestic currency by buying or selling government securities. 
• Reserve requirements are the central bank-determined amount of cash banks must have in reserve to maintain regulatory compliance. 
• Central banks can influence the present behavior of market participants by providing forward guidance. 
• Hawkish monetary policies are designed to combat inflation and are often used during periods of strong economic growth. 
• Dovish monetary policies are more lenient towards consumers and investors and encourage them to borrow and spend money. 

What Are Monetary Policies? 

Monetary policies refer to a central bank’s response to a country’s economic situation relative to its economic goals. 

Take, for example, the US central bank – the US Federal Reserve (Fed). Suppose the Fed has a target inflation of 2.5%, but the present US economy spurred inflation to rise to 4%. 

To combat this, the Fed will likely use monetary policy tools at its disposal to bring down inflation to its target level. It may adjust the interest rates to reduce the amount of money in circulation and slow down economic growth. 

Investors classify central bank policies as either hawkish or dovish. These two stances are discussed in detail in the later part of this lesson. 

Examples of Monetary Policy Tools 

Interest rates are just one of the monetary policy tools central banks can use to manage their countries’ economies and currency value. 

Other examples of these instruments include: 

Open Market Operations (OMO) 

In open market operations, central banks can buy or sell government securities in the open market to manipulate money supply and effectively control short-term interest rates. 

Reserve Requirements 

Reserve requirements refer to the predetermined minimum cash reserve a bank must have to remain compliant with central bank policies. By lowering or raising this requirement, central banks can impact how much banks can afford to set aside for lending. 

Forward Guidance 

Forward guidance is a central bank statement regarding a country’s economic outlook and the potential monetary policy course it will take. By stating in advance how they will likely act in the future, central banks affect the present behavior of market participants. 

Currency Interventions 

Currency intervention refers to a central bank’s direct intervention in the forex market to influence the value of its country’s currency. While it can be seen as a drastic measure, currency interventions are an effective way of stabilizing exchange rates and addressing economic imbalances. 

What Does a Hawkish Monetary Policy Mean? 

A hawkish monetary policy refers to a central bank’s stance when it’s actively trying to fight rising inflation. 

You can often recognize a central bank’s hawkish stance from the increased interest rates and a tighter money supply. By simultaneously limiting the amount of money in circulation and raising interest rates, central banks reduce spending and inhibit borrowing. 

A reduction in spending and borrowing helps central banks ease inflation. Central banks often adopt hawkish monetary policies during periods of strong economic growth. 

What Does a Dovish Monetary Policy Mean? 

Dovish monetary policies are a central bank’s “softer” stance regarding its country’s economic circumstances. These policies are more lenient towards businesses and consumers. 

A dovish monetary policy is characterized by lower interest rates. By lowering interest rates, central banks encourage businesses to borrow more and, in turn, spend more. 

Central banks have several aims when they take a dovish stance. These can include: 

• Promoting economic growth and increasing employment rates. 
• Encouraging business investments and consumer spending. 

Generally, central banks take on dovish monetary policies when their countries are experiencing slow economic growth.