How do central bank policies shake up the currency market? Analyzing interest rate and monetary trends from hawkish and dovish perspectives

The fluctuations in the foreign exchange market are always influenced by the shadow of central banks. Those seemingly cold and detached interest rate decisions actually directly rewrite the outcomes of every foreign currency transaction. To understand the forex market, you must first grasp the central bank’s “hawkish or dovish” stance.

The Three Main Goals and Dilemma of Central Banks

Central banks bear three seemingly simple yet conflicting missions: stabilize the economy, control inflation, and maximize employment. The problem is, reducing inflation and expanding employment often conflict with each other. When central bank officials are caught in this dilemma, two completely opposite policy tendencies emerge—hawkish and dovish.

What Are Hawkish and Dovish Monetary Policies?

Hawkish: Tightening stance, targeting inflation threats

Hawkish policymakers prioritize price stability as their primary goal. They support raising interest rates and tightening the money supply to suppress inflation. Hawkish officials warn of inflation risks with strong language and take a firm stance.

Typical case: In 2022, U.S. inflation hit a 40-year high, and the Federal Reserve decisively shifted to a hawkish stance, raising interest rates consecutively to cool down the overheated economy.

Dovish: Expansionary stance, prioritizing economic growth

Doves are the opposite; they focus more on economic growth and employment levels. Dovish policymakers tend to lower interest rates and increase liquidity, even if it brings inflation risks. They believe that economic vitality is more important than short-term prices.

Typical case: In 2020, the COVID-19 pandemic impacted the global economy, and many central banks adopted dovish policies, significantly cutting interest rates and injecting liquidity to rescue the markets.

Core Tools of Monetary Policy: Interest Rate Adjustments

What is the essence of monetary policy? It is the central bank’s means of guiding the economy in the expected direction by regulating the total money supply. And interest rates are the most critical lever in this system.

When the economy overheats and prices soar, the central bank raises interest rates to make savings more attractive, increase borrowing costs, and cool consumption and investment. Conversely, when the economy is weak and unemployment rises, the central bank lowers interest rates to make money cheaper and easier to obtain, stimulating spending and corporate expansion.

Data the central bank considers when making decisions include:

• GDP growth rate
• Inflation rate
• Unemployment rate
• Trade balance and tariffs

Differences Between Hawkish and Dovish in Practice

It’s worth noting that the stance of the central bank is not permanent. Policymakers can switch flexibly between the two positions based on economic conditions.

How Does Monetary Policy Influence the Forex Market?

Foreign exchange prices depend on supply and demand, and the money supply is directly controlled by the central bank. Therefore, monetary policy’s impact on exchange rates is immediate and direct.

Expansionary policy → Currency depreciation

When the central bank implements expansionary policies, the market perceives that the economy may slow down. Investor confidence in the country’s prospects diminishes, and foreign investment inflows weaken. At the same time, the central bank increases the money supply, leading to greater supply and lower demand, causing the currency to weaken.

Tightening policy → Currency appreciation

Conversely, tightening policies indicate a healthy economy. Higher interest rates attract foreign capital seeking returns, increasing currency demand. The central bank reduces the money supply, decreasing supply and increasing demand, causing the currency to strengthen.

How Central Bank Statements Trigger Major Forex Market Shocks?

Every word from a central bank official is scrutinized like a magnifying glass by forex traders. Any statement regarding interest rates or economic outlook can trigger intense market reactions.

When the signals from the central bank do not align with market expectations, the forex market often becomes volatile. For example, if the market expects a rate cut but officials hint at maintaining or even raising rates, traders will quickly adjust their positions, causing significant exchange rate swings.

Therefore, traders should continuously monitor central bank officials’ speeches, especially wording related to hawkish or dovish stances. These messages often precede official decisions and can already stir waves in the forex market.

In short, hawkish and dovish monetary policies influence the forex market directly through interest rate adjustments. Hawkish rate hikes push the domestic currency higher, while dovish rate cuts put downward pressure on the currency. Understanding the central bank’s policy stance is the key to mastering forex market volatility.