How Does Monetary Policy Affect Your Returns?
When it comes to studying macroeconomics and the economy’s aggregate performance, the impact of the coronavirus pandemic has provided most of us with a crash course.
Interestingly, the response to the pandemic in the UK and across Europe was characterised by a number of monetary policy decisions, which have since created additional socio-economic issues and forced central banks to further reassess their various strategies.
In this respect, monetary policy is highly influential and also capable of affecting your investment returns over time. But how is this the case, and what steps can you take to mitigate the impact of monetary policy measures?
The Impact of Monetary Policy on the Economy
In general terms, monetary policy refers to a host of strategies and techniques used by central banks to help maintain stable (and positive) economic growth.
These policies are changeable and under constant review, while they’re formulated according to the prevailing economic climate, the amount of money circulating within the economy and its real-time value.
In addition to maintaining a stable and balanced economy, central banks are also known to use monetary policy to achieve other fiscal aims.
For example, the central bank in the UK is also focused on promoting optimal rates of employment on these shores and maintaining steady consumer prices. Because of this, it has set an inflation cap target at 2%, with stable price growth within this range thought to be good for the national economy.
Not only is it apparent that monetary policy directly affects price increases, but we’ve also seen first-hand of late the impact that the central bank’s machinations can have on our standard of living.
If we head back to the summer of 2020, for example, we see that the UK’s central bank slashed the nation’s base interest rate to just 0.1%.
This was part of wider quantitative easing measures in the wake of the pandemic and subsequently lockdowns, to help ease the cost of borrowing and flood the markets with liquidity. In theory, this should have stimulated investment and consumption in the economy, ideally benefitting both businesses and households alike.
While such measures achieved their objective in the short-term, they also led to greater economic speculation and a consistent increase in inflation above the 2% mark. This reflects the inverse relationship between interest rates and inflation, as while one measure is slashed the other begins to increase and vice-versa.
Inflation and the wider cost of living reached a peak in February, as Consumer Prices Index (CPI) inflation rose to a 30-year high of 6.2%. This was up from 5.5% in January, while this trend is expected to continue until the summer at least.
Rising inflation has once again forced the central bank to act, with the base interest rate having been increased three times in four months since December 2021 (from 0.1% to 0.75%).
Each announcement was made after detailed monetary policy meetings, while further hikes haven’t been ruled out as inflation continues abound.
Over time, of course, it’s expected that this and similar measures will help to curb inflation and bring it closer to the central bank’s target of 2%.
In the meantime, however, it will also increase the cost of borrowing and household’s mortgage repayments in some instances, creating further socio-economic challenges that will need to be overcome.
The Key Considerations for Investors
These recent issues highlight the challenges facing central bank and monetary policy makers, who must regularly take decisions that are designed to solve a short-term fiscal issue but subsequently disrupt other macroeconomic factors.
This is also problematic for investors, whose trades and strategies can be adversely affected by monetary policy announcements and the measures taken to tackle specific economic issues.
The question that remains, of course, is what steps can investors take to mitigate the risk posed by monetary policy announcements and their potential impact on returns? Here are some ideas to keep in mind:
● Develop a Detailed Understanding of Monetary Policy and its Influence: Let’s start with the basics; as investors need a detailed understanding of monetary policy and its influence on macroeconomics and a broad range of asset classes. From here, they’ll need to identify the most relevant monetary policy updates and evaluate the potential risk that they pose to their particular portfolio of assets. Over time, investors can evolve to a point where they automatically factor monetary policy into their strategies and make more intuitive trades as a result.
● Learn How to Capitalise on Monetary Policy: On a fundamental level, understanding the impact of monetary policy enables you to identify key risks and navigate these. Those with a true investor mindset can also use this comprehension to leverage monetary policy changes to their advantage, usually by targeting speculative and derivative assets (such as forex). For example, lowering interest rates typically devalues local currencies, enabling forex traders to short relevant pairings to achieve a short-term profit.
● Make Use of Economic Calendars: Whether you want to simply minimise the risk posed by monetary policy announcements or leverage these to your advantage, you’ll need to make use of an economic calendar. This is an investment tool that monitors various market moving events, including key economic indicators and monetary policy data releases such as interest rate changes. The key is to highlight the relevant policy announcements based on your portfolio and wider trading strategy, while you can further filter events based on their impact level.
The Bottom Line
Monitoring fiscal policy measures is a must for investors, particularly those who trade primarily in assets such as retail stocks and forex.
These assets are most susceptible to macroeconomic factors, which are in turn manipulated as part of monetary policy strategies and liable to constant change.
Of course, the most successful investors also develop an innate understanding of monetary policy and the study of macroeconomics, enabling them to pre-empt potential changes according to the real-time market conditions.
As a result, they can time and plan their trades to fully leverage policy changes and updates, rather than leaving themselves at the mercy of unexpected interest rate shifts and inflation hikes.