Hawkish and dovish monetary policy

Federal Reserve Bank of the United States of America

If you are a trader and have been trading the currency markets for a while, you might have come across high impact news events such as central bank meetings.

During such meetings, you might hear about analysts talking about how the central bank's monetary policy was hawkish or how dovish it was. If you are wondering what these terms mean, then this article is just for you.

The volatility in the price you see surrounding such events are usually high.

Depending on the currency pair in question, you can expect to see large price movements all across the board.

In this article, we explain what is the meaning of hawkish or dovish in terms of monetary policy perspective. We also give you insights into understand what it means for the forex markets when a central bank is hawkish or dovish. At the end, this article should give you a clear picture of what it means when a central bank is hawkish or dovish.

You will also learn how to decipher the meaning from the central banks, not just during monetary policy statements but also during central banker speeches.

The forex markets, as you know are driven by the fundamentals. The fundamentals basically assess the state of the economy. The state of the economy in turn influences the central bank's monetary policy.

Monetary policy in central banks is defined as how a central bank will manage the liquidity in the markets and generates growth.

Most central banks in the world have a dual mandate. Central banks are tasked with the responsibility of maintaining price stability via managing inflation and to maintain full employment.

Depending on how an economy is faring, central banks can use their monetary policy by raising or lowering interest rates. In the forex markets, it is essentially the interest rates that dictate the price movements. When a central bank has higher interest rates, investors tend to park their money in that respective economy.

This creates demand for the currency and thus pushes the exchange rate higher. Likewise, when the interest rate of a central bank is lower, there is less demand for the currency due to lower interest rates.

Investors can also use these discrepancies in interest rates to basically borrow in one currency on cheaper credit conditions and then invest the money in another economy where the interest rates are higher. This also creates supply and demand imbalances in the currency markets, which in turn moves prices of the currencies.

Why do we need a central bank?

Before we go into the details of the meaning of hawkish or dovish monetary policy, it is essential to understand the importance of a central bank.

Ever since the U.S. dollar was de-pegged from the gold standard, it created fiat money. Fiat money is easier to manage especially when it comes to creating growth. A central bank is the only authorized financial institution that can legally print money.

Therefore, a central bank is at the core of an economy’s financial system. By using its monetary policy tools, central banks can print more money in order to stoke inflation and create growth while at the same time, central banks can reduce the supply of money in order to ensure that the economy is not overheating.

The central bank manages its monetary policy by means of controlling the interest rates. The interest rates are set by the respective central banks for every economy.

This interest rate determines how much banks pay to loan or lend money to each other.

The way a central bank communicates these messages to the general markets is by holding a monetary policy meeting. This meeting is also known as interest rate decision meetings. During such meetings, the members of the central bank which comprises of the president, vice-president and members of the board decide on interest rates.

A central bank typically holds a monetary policy meeting once a month. But the frequency can change depending on the central bank in question. The Federal Reserve for example, which is the central bank of the United States of America holds its monetary policy meeting eight times a year.

During each of these meetings, the central bank informs the markets on its interest rate decision. The way this communication is conveyed is termed as the central bank being either hawkish or dovish.

When deciding on interest rates, and whether to raise or lower interest rates, the central bank takes into account the economic indicators. These indicators include the recent GDP report, inflation report, unemployment report. At times, central banks also look at some forward looking surveys that can signal whether the economy is moving along at a healthy pace or whether there is trouble ahead.

For example, when home buying activity falls drastically over a period a few months, due to the current interest rates, the central bank can basically lower interest rates in order to make borrowing more easier. This allows home buyers to take loans at cheaper interest rates and thus afford a home.

Now that we know the importance of a central bank and how it controls the economy, let’s go a bit deeper and to the core of the issue. What does hawkish or dovish monetary policy mean?

What is dovish monetary policy?

At the end of every monetary policy meeting, the central banks issue a statement. This is known as the monetary policy statement. Many analysts and economists go through the central bank’s monetary policy statement as it conveys some important information.

For example, let’s say that the inflation in an economy has been slowing over the past few months. At the same time, the labor market has been growing at a steady pace. However, during the monetary policy meeting, the members of the board leave interest rates unchanged.

Example of dovish statement from the U.S. Federal Reserve

But in their monetary policy statement, the officials state that due to lower inflation in the past few months and inflation expectations over the next few months looking weaker, it would find it appropriate to lower the interest rates.

What the central bank is basically conveying is that due to inflation slowing, it forecasts that at some point in the near future, it would cut interest rates.

This is nothing but dovish monetary policy. When the central bank’s statement talks about weakness in the economy or that it feels about lowering interest rates in the future, this is translated as being a dovish monetary policy.

Sometimes, members of the monetary policy committee or the interest rate setting committee also make speeches publicly. During such speeches, these individuals also give their own assessment of the economy and give their opinion on whether there should be a rate hike, a rate cut or no change to interest rates.

Depending on the context, the outcome of the speech can be deemed dovish if the speech talks about the need for lower interest rates or no change to interest rates.

What is hawkish monetary policy?

Hawkish monetary policy on the other hand is the exact opposite to dovish monetary policy. Take for example you have an economy where inflation is close to the central bank’s inflation target rate. The unemployment rate is steadily falling as well, and the nation’s GDP is progressing strongly.

Based on the conditions, the central bank issues a statement that given the overall performance of the economy, it would be necessary that further rate hikes were required.

This is nothing but hawkish monetary policy.

When a central bank issues a statement or communicates the fact that interest rates need to rise, it signifies that the monetary policy is hawkish.

Difference between hawkish and dovish monetary policy

Hawkish vs. dovish monetary policy

Hawkish monetary policy

Dovish monetary policy

  • Hawkish monetary policy is usually targeted when inflation is high. Hawkish monetary policy language is used to fight inflation when it starts to rise above the central bank's target rate

  • Hawkish monetary policy is also used when the central bank feels that the economy is expanding strongly and could overheat. This could potentially lead to a recession and as a result, the central bank uses hawkish monetary policy to cool the economy from overheating

  • Hawkish monetary policy is usually favorable for the currency as it appreciates
  • Dovish monetary policy is used in order to push inflation closer to the central bank’s inflation target rate. Dovish monetary policy is supportive of inflation and is used when consumer prices fail to rise

  • Dovish monetary policy is also used when the central bank notices that the economy is slowing or that the unemployment levels are highs. Dovish monetary policy aims to support the economy which is slowing and could potentially slip into a recession

  • Dovish monetary policy is not favorable for the currency as it results in the exchange rate depreciating

Meaning of dovish and hawkish in forex

So far, we gave an explanation of how central bank monetary policy meetings can be distinguished between dovish or hawkish.

Depending on how the markets perceive the central bank’s statement, the currency markets tend to react accordingly. One of the things to bear in mind is that the markets are always forward looking. Therefore, even before the central bank meeting is held, the markets always move in a certain direction expecting a certain outcome from the central bank.

This brings the commonly used phrase, of buy the rumor, sell the fact. The markets already position themselves in anticipation of the outcome of the meeting. However, after the meeting, depending on the outcome, the market reaction can vary.

Therefore, when looking at the meaning of hawkish or dovish in the forex markets, it is basically the expectations. The markets already discount the expectations and then look forward to the actual outcome of the meeting.

So, when you hear that a central bank was dovish than expected or hawkish than expected it could lead to strong market reaction.

Typically, when a central bank is hawkish it is good for the currency in question. When a central bank is dovish, it is bad for the currency in question.

For example, if the U.S. Federal Reserve came out hawkish than expected, then the USD would appreciate. Or if the European Central Bank comes out dovish than expected, then the EUR would depreciate.

Meaning of Hawkish and dovish – Conclusion

In conclusion, hawkish and dovish are two terms that you will constantly come across if you are actively trading the forex markets. These terms basically signify the outlook or the intention of the central bank. When a central bank is hawkish it means that the currency in question will appreciate as the central bank is aiming to raise interest rates

Similarly, when a central bank is dovish, it would have a negative impact on the currency in question. This happens because the central bank’s intention is to lower interest rates in order to stimulate the economy.

One of the classic examples of dovish monetary policy was the immediate aftermath of the 2008 global financial crisis. After the U.S. sub-prime mortgage bubble burst, economic growth faltered. This led to various economies across the world slowing.

As a result, many central banks especially in developing economies had to come out with a dovish monetary policy. Interest rates were cut, and central bank undertook additional steps in order to inject more liquidity into the markets.

This led to many currencies depreciating as a result.

Another example on the flipside is the U.S. Federal Reserve which began to hike interest rates since December 2015. This came after the dovish monetary policy saw the U.S. short term interest rates being lowered to record lows of 0.25%.

However, since then, the Federal Reserve has been steadily hiking interest rates leading to a broad appreciation of the U.S. dollar.

While many traders tend to focus on the technical aspects of trading, trading the financial markets also requires one to pay attention to the fundamentals. While there are many fundamentals, the central bank meetings and speeches by key central bank officials are important as they form the core of the price movement in the currency markets.

 

About Me

I'm Mike Semlitsch the owner of PerfectTrendSystem.com. My trading career started in 2007. Since 2013 I have helped thousands of traders to take their trading to the next level. Many of them are now constantly profitable traders. 

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