The Impact Of Fiscal Policy
We just have a quick question here from Adam, asking how does fiscal policy in general affect a currency?
There are two different policy types. First we have monetary policy and relating to the question is fiscal policy. Now, looking to monetary policy, that is normally the responsibility of the central bank. The purpose of monetary policy is to achieve the central bank’s mandate.
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Now, the tools used more commonly by central banks to affect monetary policy changes is adjusting the interest rate, doing open market operations, changing reserve requirements and also unconventional tools, like quantitative easing.
The expected impact on the currency when we have a softer monetary policy, basically a reduction of interest rates, introduction of quantitative easing that is to have a negative impact on a currency and tighter monetary policy, basically an increase in interest rates is expected to have a positive impact on a currency. Now, looking to fiscal policy, the people responsible is the government.
The purpose is mostly to boost economic growth, and the tools used are normally big spending projects, fiscal spending in the real economy, for example, big infrastructure projects and some of the other tools are a reduction of public and corporate taxes.
The expected impact of fiscal policy is more fiscal policy is normally expected to have a positive impact on the economy and thus the currency, where less fiscal spending is expected to have a negative impact on the economy, as well as the currency. Now, how can we use this information in our trading? This is where the Financial Source terminal comes in very handy. So firstly, we can use our current sentiment drivers report for each of the major currencies, to tell us whether the market has any specific expectations for fiscal policy from a particular country.
So, just as an example, let us suppose for a second that the market is expecting and waiting for a very big fiscal policy with 100 billion pounds to be announced for the UK. When that news first came up, and in the run up to that announcement, that should be a positive thing for the pound, if that is the only driver for the pound at that time. Secondly, after knowing what that current expectation is, we can then turn to the audio squawk and the regular news feed that we have in the terminal. So, we know that the current expectation is for that big stimulus program, so any news that changes that current expectation, can be market-moving and tradable.
For example, let’s say news comes out that the 100 billion proposed fiscal spending won’t work due to budget restraints, and some sources close to the chancellor is saying that it’ll be closer to 20 billion, not 100 billion. Now that would be a big disappointment, from the current expectations and would be tradable to the downside for the pound, just as an example. And vice versa, if we get an announcement over the squawk, that says it’s actually close to 200 billion, not the 100 billion previously thought, that would be a big positive change and we could look to buy the pound on news like that. Now again, this is just a hypothetical example.
However, keep in mind, when the world is facing really immense economic uncertainty and huge economic slowdowns like a global recession, even very big announcements from fiscal spending might not be enough to really move the market unless the market is convinced that the measures being put in place will be enough to limit economic downturns. Also keep in mind, during times of immense economic uncertainty the US dollar is usually seen as a safe haven currency.
Thus, big stimulus packages during recessionary periods in the US might actually turn out to be dollar negative, and not dollar positive. As the sentiment surrounding the dollar’s strength during times like that might be different compared to other normal parts of the economic cycle.
So, I hope that helps there, Adam. If there’s any other questions about monetary and fiscal policy, please make sure to let us know.