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Central Banks and Monetary Policy: How Central Bankers Set Policy

  • Central Banks look at a variety of economic data and projections before setting policy.
  • These datapoints are then applied to the central bank’s operating framework in order to determine if a policy change is needed.
  • To actually set policy, central banks turn to their implementation divisions, which transact in financial markets to enact policy.

How Central Banks Set Policy

Central bank policy is an important driver of movements in financial markets. Central bank officials gather, project, and analyze economic data to determine the future path of the economy and its relation to the bank’s policy goals. Challenges or deviations from the ideal path of the economy will often drive a central bank to policy action. However, the setting of a central bank policy is not as simple as issuing a press statement declaring a change in interest rates, an adjustment to asset purchases, or further supportive measures. Central bank policies must also be implemented through transactions in financial markets.

Central bank policies have a direct and oftentimes immediate impact on the FX markets. As central banks loosen or tighten policy, their respective currencies become more or less attractive to hold. Understanding the process by which central banks make such decisions is a valuable skill to any trader, as being able to predict what a central bank might do will give a greater depth of understanding to each key economic data release.

Mandates and Price Stability

While the US Federal Reserve is the most watched and most important of the central banks, it’s mandate exceeds that of the average central bank. The Federal Reserve is dually focused on maximum employment and price stability, while most central banks are focused exclusively on the price stability mandate. Price stability is best defined as low, stable, and predictable inflation. Most central bank’s target an inflation level of around 2%, which is viewed as a good indicator of strong and stable economic growth. When making monetary policy decisions, central banks must weight a variety of economic indicators, expectations, and conditions.

Economic Data

Central banks parse the same economic data that FX traders and other market participants watch closely. Unemployment, housing, and inflation are some of the key data points central bankers track as they meet to discuss and set policy. These indicators are important to GDP and to identifying expanding or slowing trends in a large economy. The DailyFX Economic Calendar is a great tool to help traders monitor the same data releases that central bankers are keeping a close eye on.

Projections, Economists

Beyond following the same economic data that market participants have access to, central banks employ hundreds of economists. These economists are specialized in a certain area of expertise and are often considered leaders in their field, making them the best choice to hold the responsibility of creating the projections that central banks will use to set policy. Economists create and model economic projections of the future path of the economy based on current data, expectations for the future, their knowledge of the subject area, and potential policy choices.

Central bankers use these models to anticipate where the economy is headed next and help evaluate the potential impact of their policy choices. Many central banks publish summaries of their economic and policy projections on a consistent basis, and these summaries are a valuable resource for traders looking to understand how an important driver of markets is viewing overal