Introduction

The concept of monetary policy revolves around the regulation of the money supply to achieve specific economic objectives. While a steady issuance of money is vital for economic stability, this must be carefully balanced to control inflation, employment, and stimulate economic growth. With the execution of actions such as open market operations, adjusting reserve requirements, and setting interest rates, central banks aim to ensure a steady and controlled flow of money in the economy while addressing broader challenges like currency stability and long-term economic health.

Cryptocurrency volatility stems from a wide range of factors. As a speculative market, it is susceptible to market sentiment, which can cause significant price fluctuations. One of the major external influences on cryptocurrency prices is monetary policy, a tool governments use to influence the supply and demand of money within an economy.

This article will explore how monetary policy shapes economic factors like interest rates and inflation, and, ultimately, how it affects the cryptocurrency market.

What is Monetary Policy?

Source: Investopedia

Monetary policy refers to the actions taken by a country’s central bank or monetary authority to manage the money supply and control interest rates in the economy. The main goal of monetary policy is to achieve economic stability by managing inflation, ensuring price stability, and creating conditions for healthy economic growth.

It is best described as how the government controls the “flow” of money in the economy. If too much money flows, prices can rise too quickly (inflation). If there’s too little, businesses and people may not spend enough, leading to slower economic growth or recession. Central banks like the Federal Reserve (United States of America) or the European Central Bank control this flow by changing interest rates, regulating how much banks can lend, or buying and selling government bonds.

Central Banks use the following tools to control monetary policies;

• Interest Rates
• Open Market Operations
• Reserve Requirements

Interest Rates

Interest rates are the percentage charged by lenders or paid by borrowers for using money. They are a crucial tool in personal finance and broader economic policy, directly influencing the cost of borrowing and the return on savings. The rate (policy rate) a central bank sets influences other interest rates in the economy, such as the rates on loans and savings. It’s the rate at which banks borrow money from the central bank. Examples include the Federal Funds Rate in the U.S. or the European Central Bank’s main refinancing rate.

Open Market Operations

Open Market Operations (OMO) refers to the buying and selling of government securities (Treasury bills, Treasury notes, or Treasury bonds) by a central bank in the open market to regulate the money supply and influence short-term interest rates. When a central bank buys government securities it pays for them using money from its reserves. The money used by the central bank to purchase these securities goes into the banking system. This increases the reserves of commercial banks, which means they have more money available to lend out or invest.

Additionally, when a central bank sells government securities, it receives money from the buyers. The money paid for these securities is taken out of the banking system. This reduces the reserves of commercial banks, limiting their ability to lend money or make investments.

Reserve Requirements

Reserve requirements refer to the minimum amount of funds a bank must hold in reserve and cannot lend out. These reserves are held as a percentage of the bank’s deposit liabilities and are usually kept either in the bank’s vault or deposited with the central bank. Central banks, such as the Federal Reserve (U.S.) or the European Central Bank (ECB), set these reserve rates as monetary policy tools to control the money supply and ensure financial stability.

Types of Monetary Policy

Monetary policy can generally be divided into two types based on the central bank’s goals: Expansionary and Contractionary monetary policy.

Expansionary Monetary Policy

Source: CorporateFinanceInstitute

Expansionary monetary policies increase the money supply or lower interest rates to stimulate economic activity. It is typically used during periods of slow economic growth or recession to encourage borrowing, spending, and investment.

In an Expansionary Policy, the Central Banks will;

• Reduce interest rates, making borrowing cheaper for businesses and consumers.
• Buys bonds from financial institutions, injecting money into the economy and increasing liquidity.
• Reduce reserve requirements for Banks, allowing them to lend more to businesses and individuals.

The Federal Reserve’s Intervention During the COVID-19 Pandemic

The Federal Reserve cut the federal funds rate to a target range of 0% to 0.25%, the lowest since the 2008 financial crisis. It made massive bond purchases, buying Treasury securities and mortgage-backed securities. In coordination with the U.S. Treasury, they also set up several emergency lending facilities to ensure credit flow to various parts of the economy.

At its peak, the Federal Reserve purchased $120 billion monthly ($80 billion in Treasuries and $40 billion in mortgage-backed securities). They also temporarily relaxed regulatory requirements on Banks to allow them to lend more freely.

Contractionary Monetary Policy

Source: CorporateFinanceInstitute

Contractionary monetary policies reduce the money supply or raise interest rates to slow down economic activity. It is used to combat high inflation and prevent the economy from overheating.

In a Contractionary Policy, the Central Bank will;

• Increase interest rate, making borrowing more expensive. This reduces consumer and business spending.
• Sell government bonds, reducing the amount of money circulating in the economy.
• Increase reserve requirements for Banks, allowing them to hold more money in reserve, and limiting the amount they can lend out.

The Federal Reserve Policy of 1980

Following the high inflation that plagued the U.S. economy in the late 1970s, The Federal Reserve aggressively raised interest rates to nearly 20%. This triggered a stable economic situation.

How Monetary Policy Affects Cryptocurrency

Monetary policies play a significant role in shaping market sentiment. Investors closely monitor Federal Reserve announcements on interest rates, as it influences their trading positions.

Expansionary Policies have been shown to favor the crypto market, as there’s enough liquidity in the economy to stream into the Crypto market. In contrast, Contractionary policies reduce the money supply in the economy reducing the price of cryptocurrencies.

Case Study of The 2020 Fed Rate Cut

Expansionary policies such as the Federal Reserve’s intervention to reduce the economic effects of the COVID-19 Pandemic, led to several key financial shifts.

As interest rates were lowered, borrowing became cheaper, and returns on traditional savings declined. Investors sought higher returns in alternative assets like cryptocurrencies, increasing demand and increasing crypto prices. Investors also turned to cryptocurrencies as an alternative store of value, believing digital assets, particularly those with limited supply (like Bitcoin), will retain value better. This shift also contributed to increased demand and rising prices for cryptocurrencies.

Bitcoin (BTC)
In March 2020, Bitcoin initially dropped to around $3,800 due to market-wide panic.

Source: Coinmarketcap

Following the Fed’s interventions, Bitcoin began a strong upward trend. By December 2020, its price surged to around $29,000, a new all-time high.

Ethereum (ETH)
Ethereum also dropped during the March crash, reaching lows of around $100.

Source: Coinmarketcap

With the Fed’s policies, ETH rebounded, and by December 2020, it reached around $730, benefiting from the rise of decentralized finance (DeFi).

Many altcoins experienced a similar pattern of sharp drops followed by large recoveries, although to varying degrees. Some notable altcoins like Chainlink (LINK) and Cardano (ADA) showed impressive gains as the market regained confidence.

Chainlink (LINK)
Chainlink (LINK) rose from about $2 in early 2020 to over $12 by the end of the year.

Source: Coinmarketcap

Cardano (ADA)
Cardano (ADA) increased from around $0.03 in March to about $0.18 by December 2020.

Source: Coinmarketcap

Case Study of The 2022 Fed Rate Hike

The Federal Reserve’s response to rising post-pandemic inflation in 2022, led to several key economic adjustments. By raising interest rates in successive increments, reaching up to 4.5% by December 2022, the Fed reduced liquidity in financial markets as borrowing became more costly, and the returns on safer assets like savings accounts and bonds increased. Consequently, investors shifted their capital toward these income-generating, lower-risk assets, moving away from more volatile options like cryptocurrencies. This shift in investment preference decreased demand for cryptocurrencies, leading to a corresponding drop in their prices.

Bitcoin
Bitcoin fell from around $47,000 at the start of 2022 to as low as $15,500 in November 2022, marking a significant bear market.

Source: Coinmarketcap

Altcoins followed a similar pattern, with Ethereum dropping from about $3,700 in January to around $1,100 by the year’s end.

Ethereum

Source: Coinmarketcap

Chainlink

Source: Coinmarketcap

Cardano

Source: Coinmarketcap

Although Monetary Policy plays a crucial role in shaping broader market conditions, other factors contribute to the price action of cryptocurrencies.

The 2020 upswing in Bitcoin’s price was also influenced by the Bitcoin Halving event, which reduced the supply of new Bitcoins entering circulation.

The 2022 downtrend was also related to the fall of Terra Ecosystem, including its stablecoin UST and token LUNA, which led to a significant loss of confidence, with ripple effects across the crypto market. FTX, one of the largest crypto exchanges at the time, fell due to allegations of mismanagement and fraud, shaking investor trust in centralized platforms and causing major sell-offs.

Conclusion

Monetary policy plays a key role in maintaining economic stability. It involves controlling interest rates, managing inflation, and regulating the money supply. It has a significant impact on both traditional financial markets and cryptocurrency markets. Cryptocurrencies are sensitive to liquidity changes driven by traditional monetary policy. Expansionary policy can lead to more money flowing into crypto assets, while contractionary policy reduces available capital for riskier investments, often leading to price drops.

However, investors are advised to consider monetary policies and factor in technological advancements, real-world use cases, regulatory changes, market sentiment, and broader economic trends when making investment decisions.