Financial markets and monetary policy implementation - an evolving relationship
|Since the global financial crisis in 2008, the relationship between monetary policy and the financial markets has shifted in some respects. From a central bank perspective, this shift mainly affects the transmission of monetary policy - that is, how monetary policy stimuli are passed on to the economy and prices via the financial markets. Prior to the financial crisis, central banks used a single instrument to implement their monetary policy. As a rule, this was a short-term interest rate steered more or less directly by the central bank. Thus, monetary policy transmission started with the money market and, from there, was transmitted to the economy via a number of different channels - including interest rates, credit, exchange rates and asset prices.
During the financial crisis, central banks reduced their reference rates to levels of or close to zero. The conventional interest rate instrument had thus reached its limits, according to the prevailing view at the time. In order to ensure the continuing transmission of monetary policy, central banks turned to unconventional measures, some of which no longer use the money market but instead target the capital and foreign exchange markets directly. This has increased the sphere of action of monetary policy, and the influence of central banks on the financial markets has expanded as a result.
The use of unconventional measures poses some challenges for the implementation of monetary policy. For the Swiss National Bank, whose monetary policy is based on a negative interest rate and foreign currency purchases, it was necessary to deepen its understanding of the market, refine its analytical tools and strengthen its market contacts.
If central banks exert a greater influence on financial market prices than previously, this could result in these prices becoming disconnected from the real economic environment, and only reacting to monetary policy. In fact, we observe that some traditional relationships and correlation patterns on the financial markets have changed in recent years. However, in addition to unconventional monetary policy measures, this is also due to the globalisation of financial markets and parallel economic and price developments. Moreover, the phenomenon of interpreting bad news from the economy as good news for the markets already existed before the financial crisis, especially on the equity markets. The question of just how much the greater activity of central banks on the financial markets has changed the traditional price relationships and correlation patterns is difficult to answer definitively. Ultimately, financial market prices continue to reflect investor expectations for the future development of the economy and inflation.
Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Open Markets involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of FXStreet nor its advertisers.