Hawkish Monetary Policy

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21 Aug, 2024

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A hawkish monetary policy refers to an aggressive monetary policy implemented by a nation's central bank when it wants to contract financial liquidity. The purpose of implementing such a policy is to maintain healthy employment levels, and minimize rising prices, thus avoiding recession.

Such monetary policies reduce the overall currency in circulation, which leads to the appreciation of the respective currency's value. Such policies may involve increasing the benchmark fed funds rate, increasing reserve limits for financial institutions, including commercial banks, and selling government-backed financial instruments in the open market. These measures lead to lower inflation rates and a stronger currency value.

What Is Hawkish Monetary Policy?

Hawkish monetary policy meaning refers to a monetary policy that a country's central bank implements to fight inflation by reducing the overall currency in supply within the economy. It can help governments ensure healthy employment levels while minimizing rising prices.
In the long run, such a monetary policy can lead to deflation. Some tools of this policy are the discount rate, money supply, and reserve requirements.
A key difference between the dovish and hawkish monetary policy is that the former involves increasing the total currency circulating in the economy, while the latter involves reducing it.

Hawkish Monetary Policy Explained

Hawkish monetary policy meaning refers to a monetary policy that involves a central bank like the Federal Reserve raising interest rates, thus increasing the cost of borrowing. It aims to fight inflation. Generally, the Federal Reserve uses it when there are concerns that the inflation rate will exceed or is already higher than the target of 2%. According to the Fed, if inflation remains at 2% over the long term, it consistently balances maximum employment and price stability.

Whether or not the hawkish monetary policy stance is appropriate depends on the economy's strength and various other macroeconomic factors. After all, such a policy involves raising the federal funds rate, which impacts other interest rates and leads to a higher cost of borrowing. This, in turn, weakens demand and discourages spending. Because of the decreased demand, prices fall, which helps reduce inflation. Moreover, it may lead to businesses hiring fewer workers or reducing their workforce.

Thus, while a hawkish policy can decrease inflation, it can also cause economic contraction and increase unemployment. Moreover, it can backfire and result in deflation.

Tools

When the Federal Reserve aims to contract liquidity using such a policy, it can use different tools. Let us look at some of them.

Money Supply: Such a policy may involve decreasing the money supply in the economy via the sale of government-backed securities to member banks. This reduces the funds the banks need to lend, which again has a tendency to increase the rates of all types of loans.
Interest On Reserves: The Federal Reserve makes interest payments to banks on the amount the latter must keep in reserve. A hawkish policy raises this rate, encouraging the commercial banks to hold additional funds in reserve, and offer loans at a higher interest rate.
Discount Rate: This refers to the interest rate imposed on banks by the Federal Reserve. A hawkish policy involves raising this rate, which means higher interest rates on credit cards, mortgages, and other loans.
Reserve Requirements: Banks must keep a specific amount in reserve to ensure the banking system is stable. If the Federal Reserve increases the amount required, it will take funds out of circulation and lead to a rise in interest rates. Moreover, it will reduce credit availability.

Examples

Let us look at a few hawkish monetary policy examples to understand the concept better.

Example #1

The experts at ING Group expected the Bank of Canada to keep the policy rate at 4.5% in the second week of June 2023. However, following the stronger-than-anticipated consumer price inflation and gross domestic product or GDP, along with the labor data staying robust, they could not rule out a surprise increase in the interest rate. The market was pricing a 25% increase on June 7, and a hawkish monetary policy stance would have been sufficient to ensure that the Canadian dollar remained supported.

Example #2

Suppose the inflation rate in the U.S. was over 3%, showing no signs of decreasing. Both demand and spending were quite high within the economy. The Federal Reserve adopted a hawkish monetary policy stance to bring down inflation to its target of 2%. The measures taken by the central bank included increasing the discount rate and raising the reserve requirements for banks. Both measures contracted financial liquidity within the economy and reduced the inflation rate.

Impact

One can understand the effects of this policy in the long run by going through the points below:

This policy raises interest rates, increasing the borrowing cost for companies and individuals.
Unemployment may rise, and pay rises might be rare.
The prices of food, fuel, and various other products are less likely to rise.
Finding a job can be challenging for individuals.

Moreover, a hawkish policy decreases the overall currency circulation in the market, decreasing its value in the forex market.

Advantages And Disadvantages

Let us look at the benefits and limitations of this policy.

#1- Advantages

It positively impacts the savings rate as people are less likely to avail of loans.
Such a policy can decrease imported goods' prices if the trading partners do not raise their interest rates, but the Fed does.
As a result of this policy, tourists visiting foreign destinations may have higher purchasing power.
Banks can offer loans more freely. Thus, people can get financial assistance easily.
It can eliminate runaway inflation.

#2 - Disadvantages

It can lead to deflation, which could be more harmful than moderate inflation for an economy in the long run.
The hawkish monetary policy stance makes loans more expensive for firms and consumers.
Higher interest rates on loans, for example, mortgages and auto loans, can lead to a fall in house and car prices, respectively.
It negatively impacts domestic manufacturers.
Companies may not want to hire more employees or retain workers owing to this policy.

Hawkish Monetary Policy vs Dovish Monetary Policy

The concepts of dovish and hawkish monetary policy can be confusing if one is new to finance. Understanding their key differences can help individuals avoid confusion regarding their meaning and purpose. So, let us dive into the differences between these two types of stances.

Hawkish Monetary Policy	Dovish Monetary Policy
This policy aims to reduce financial liquidity.	It aims to increase the overall currency in circulation.
This policy involves increasing interest rates to curb inflation.	A dovish policy involves decreasing interest rates to keep inflation in check.
In this case, a central bank reduces its balance sheet through the sale of treasuries and mortgage-backed securities.	A central bank increases its balance sheet via quantitative easing.
Central banks' forward guidance includes positive statements regarding the inflation outlook, economy, and economic growth.	Central banks' forward guidance includes negative statements regarding signs of deflation, economic growth, and the economy.

Frequently Asked Questions (FAQs)

1. When is hawkish monetary policy Implemented?

Central banks execute such a policy when inflation rises within the economy rises, which may result from economic growth 'overheating.' In such a situation, the overall currency in circulation is high. The central bank takes certain measures, which may include increasing interest rates and raising interest on reserves to reduce the inflation rate.

2. Is hawkish monetary policy good?

Whether or not the implementation of such a policy is good or bad depends upon the economy. This type of policy usually favors savers and lenders besides making traveling and imports cheaper. That said, one must remember that it can lead to deflation in the long run. This means the central bank may end up sacrificing consumer spending, employment, and economic growth to keep the inflation rate under control.

3. How to benefit from hawkish monetary policy?

On account of this policy, the central bank increases interest rates, and because of that, banks may give out loans easily. Moreover, if a nation raises its interest rates while its trading partners do not, the price of imports decreases.