Why do central banks tighten and ease policy rates?

The mission of central banks around the world is to keep their respective economies stable – not too hot, not too cold, but just right. In particular, the mandate of the Bangko Sentral ng Pilipinas (BSP) is to promote low and stable inflation conducive to balanced and sustainable economic growth.

It is important for investors to understand why central banks around the world tighten and ease policy rates. Monetary policy affects different asset classes across the board—from equities to bonds to currencies.

What is monetary policy?

Monetary policy is a type of economic policy that the BSP uses to control the overall supply of money that is available to the country’s banks, consumers, and businesses. With an array of tools at its disposal for the task, its ability to influence interest rates is its most important and effective monetary policy tool.

When we hear talk about the BSP raising interest rates, it is referring to the Overnight Reverse Repurchase Rate. The Monetary Board holds monetary policy meetings eight times a year, with meeting intervals of six to eight weeks to deliberate, discuss, and decide on their appropriate monetary policy stance to keep inflation within the target.

In the US, it is called the Federal Funds Rate or the Federal Funds Target Rate. At its regular meetings, the Federal Open Market Committee (FOMC) sets a target range for the federal funds rate.

It is the key short-term interest rate that is considered the most important benchmark for interest rates in the US economy and influences interest rates throughout the global economy as a whole.

When do central banks tighten and ease monetary policy?

Suppose the economy is growing at a very fast rate, along with the inflation rate. In this case, the central bank may decide to use a contractionary or tight monetary policy to keep inflation within their target band.

Higher interest rates make it more expensive to borrow money and more appealing to save. This makes people less likely to buy goods and avail of services and makes businesses less likely to invest.

This decreases the supply of money in circulation, which then lowers inflation and moderates or cools down economic activity. When both consumption and investment spending by businesses decreases, the overall demand for goods and services in the economy goes down as well.

On the other hand, suppose the economy weakens and the inflation rate is decreasing. A central bank may decide to use an expansionary monetary policy to provide a stimulus for the economy.

Lower interest rates decrease the cost of borrowing money, which encourages consumers to increase spending on goods and services, while businesses will want to invest more for expansion purposes. This raises the supply of money in circulation, which increases inflation and ramps up economic activity. The increase in both consumption and investment spending by businesses increases the overall demand for goods and services in the economy.

What are the effects of monetary policy on the financial markets?

On Stocks

Higher market interest rates can have a negative impact on the stock market. When rate hikes make borrowing money more expensive, the cost of doing business for companies rises. Higher costs and less business could mean lower revenues and earnings for public firms, potentially affecting their stock values. Investors cannot expect much stock price appreciation if a company’s growth and future cash flows are expected to be low. The opposite is true for lower rates.

On Bonds

To recall, bond prices and interest rates move in opposite directions. When the central bank increases rates, the market prices of existing bonds immediately decline. New bonds issued in the market will offer higher interest rate payments. Existing bonds will have to decline in price to make their lower interest rate payments more appealing to investors. The opposite is true for lower rates.

On Currencies

Generally, higher interest rates increase the value of a country’s currency. Higher interest rates attract foreign investments, therefore increasing the demand for and value of the country’s local currency. For instance, if the Fed raises the federal funds target rate, there will be stronger demand for the dollar, while the peso will lose value or depreciate.

Overall, the central bank acts like a thermometer, taking the economy’s temperature to see if it is overheating or not.

GERALDINE WAMBANGCO is a Financial Markets Analyst at the Institutional Investors Coverage Division, Financial Markets Sector, at Metrobank. She provides research and investment insights to high-net-worth clients. She is also a recent graduate of the Bank’s Financial Markets Sector Training Program (FMSTP). She holds a Master’s in Industrial Economics (cum laude) from the University of Asia and the Pacific (UA&P). She takes a liking to history, astronomy, and Korean pop music.