How US Economic Stimulus Measures Influence the Forex Market
When a country’s economy faces a downturn, it is the government’s responsibility to boost it. This is the basis on which economic stimulus was initiated. Economic stimulus is a form of support or antidote for an economy in recession. It aims to increase household consumption and incentivize businesses.
Like every other economic policy, economic stimulus measures have ripple effects on income, household and corporate expenditures, and investment opportunities. This piece discusses the various elements of economic stimulus measures and offers practical suggestions for the best investment options.
How Economic Stimulus Work
While economic stimulus may be beneficial momentarily or in the long term, it is an effort by governments to manipulate economic growth with their financial tools. The federal government often adopts fiscal and monetary policies to stimulate economic growth, while state and local governments adopt projects and policies that support investments in private businesses.
Governments initiate economic stimulus by approving tax cuts, deficit spending, reduced interest rates, or new credit creation. These factors increase private sector consumption and investment, creating a “stimulus-response” effect in which the beneficiaries of this intervention make conscious efforts to boost the economy.
In layperson terms, the government reduces taxes or interest rates so that individuals, households, and businesses can have spare cash to spend. This is done with the belief that people will likely spend the extra money since human needs and wants are unlimited.
Type of Economic Stimulus in the United States
It is often assumed that there are only two types of economic stimulus because the Federal Reserve develops monetary policies while lawmakers develop fiscal policies. However, based on the goals and functions of economic stimulus actions, there are three types of economic stimulus measures in the U.S. They are:
Monetary Stimulus
This reduces interest rates, incentivizing people to get more loans and credits. With more money in circulation, people will spend more and save less. While this may positively impact household income and expenditures, lower interest rates weaken exchange rates and increase exportation. The ripple effect is more income from exportation, which stimulates economic growth.
Fiscal Stimulus
This typically involves reducing taxation. The ripple effect is increased spending as people have more disposable income. This heightened demand for commodities boosts production and spurs economic growth. With reduced tax revenue, the government compensates for the deficit by increasing its spending. Therefore, the government aims to mitigate unemployment rates and other recessionary effects.
Quantitative Easing
This is a last resort when monetary stimulus falls through. This is when the government, through the central bank, invests in or supports private financial institutions. A good example is when the central bank purchases bonds and other assets from different financial institutions. This will increase the financial institutions’ excess reserves so they can approve more loans and increase the supply of cash. However, this will also increase the price of bonds, reducing the expected yield and coupon.
How Economic Stimulus Measures in the U.S May Affect Forex Market
Economic stimulus aims to achieve a “multiplier effect” to create economic growth that cancels the financial deficit. To achieve this, governments can attempt to manipulate cash flow by reducing taxes and interest rates. While these changes may seem simple initially, they eventually lead to varying currency value changes. The impact of any economic stimulus depends on the specifics, but fiscal and monetary policy can have a considerable effect on the economy and, thus, the markets. In forex trading and the forex market generally, currencies adjust well to changes in any economic stimulus.
Higher interest rates will increase the currency’s value and attract foreign investment. On the other hand, lower interest rates reduce foreign investment and currency value. Cutting interest rates causes the country’s currency to depreciate as consumers transfer their funds to other currencies that provide higher savings returns. Quantitative easing tends to do the same by increasing the amount of money in circulation and diluting the value of all existing money.
Regarding tax, reduced tax means more income, which means people have more disposable cash. This will lead to an increase in importation. More people will be exchanging United States dollars (USD) to buy these imported items, which decreases the dollar exchange rate and will subsequently lead to an increase in the price of the imported items.
Traders should closely watch central bank decisions, mainly changes in key interest rates and policymakers’ future outlook. The challenge lies in analyzing the various components of an economic stimulus package to fully understand the details. This analysis enables traders to adapt their strategies to new market conditions and helps investors adjust their portfolios accordingly.
Economic Stimulus and Its Implications for Forex Trading
Economic stimulus actions in the United States have varying impacts across markets, with the foreign exchange market experiencing the most significant changes. Governments use monetary and fiscal strategies, like altering interest rates and cutting taxes, to boost economic growth. These actions create waves that influence currency rates, affecting forex trading. Traders who grasp these effects on currency values can capitalize on opportunities to profit.
