In my opinion, monetary policy is largely a fiat matter — meaning a central banker, if determined enough, can expand or contract the supply of money as they please. If money supply is expanding, it is reasonable to expect prices to increase, and a bubble to possibly form in a given sector. If money supply is contracting, we can expect prices to likely decrease, and a bust to occur in a given sector. Which sector bubbles and busts will appear in depend on other economic factors.
Because monetary policy is dependent largely upon the will of central bankers, understanding the psychology of central bankers is extremely critical. In terms of what news to pay attention to, news that reveals whether the central bankers want inflation or deflation, and how determined they are to reach their objectives, is particularly important. It is also worth observing whether free market forces are in line with or opposed to central banker objectives. If there is opposition, we should then ask ourselves whether central bankers are sufficiently determined to overpower free market forces and create the monetary policy they desire. For instance, over the past several decades, the Bank of Japan has seeking to create a weaker currency, but has not been able to do so due to market forces.
Whether central bankers are achieving their desired outcome can be gauged largely through exchange rates as well as official money supply indicators. For this reason, monitoring changes in money supply can be a very useful tool for traders in understanding how an economy is changing, and whether central bank objectives are being reached. Central banks typically report changes in money supply on their respective web site on a regular schedule.
In addition to money supply indicators, traders should of course watch the interest rate targets stated by central banks. As a general rule of thumb, high interest rates lead to stronger currencies, as investors will put money into currencies that give them a higher rate of return.
By understanding the desired policy of central bankers and gauging how successful they are in implementing this policy, trader can best understand how capital within an economy is moving — which in turn enables profitable trading opportunities to be identified and capitalized upon.
