Monetary policy

A central bank is given an objective by statute, most commonly price stability, sometimes paired with employment or with the stability of an exchange rate. Policy is the set of instruments it uses to pursue that objective. The principal one is the policy interest rate, which anchors the rate at which banks lend to each other overnight and, through that, the whole structure of borrowing and deposit rates in the currency. Decisions are taken by a committee on a published calendar, and the decision itself is one of three parts, alongside the vote and the accompanying statement.

Beyond the rate sit the balance sheet instruments. Asset purchases, known as quantitative easing, add reserves to the banking system and press down on longer term yields; the reverse operation withdraws them. Reserve requirements, standing facilities and, in some economies, direct operations in the currency market are also policy instruments. Forward guidance, which is language about the likely path of policy rather than an action, is treated as an instrument in its own right, because expectations about future rates are what most longer term prices are built on.

Two points matter for reading the reaction in markets. Policy is not fiscal policy: taxation and government spending are decided by a treasury, and the two can pull in opposite directions. And a market prices the expected path, not the current level, which is why an announced change that was widely anticipated can move a currency very little while an unchanged rate accompanied by altered language moves it a great deal. Where a currency is pegged, domestic policy is largely subordinated to maintaining the peg, so the rate follows the anchor currency's rather than local conditions.