Hawkish and Dovish: Key Features and Differences

The terms hawkish and dovish are commonly used to describe the monetary policy stance of central banks. They reflect their approach toward interest rates, inflation targets, and economic growth.

Let's explore the meaning of these approachhes, how these they are used by the FED, and their implications for traders.

What Does Hawkish Policy Mean?

Hawkish monetary policy is a stance taken by central banks to tighten monetary policy. This approach is typically used to combat high inflation or to prevent an economy from overheating. 

Central banks like the Federal Reserve (FED) adopt a hawkish stance when inflation rates surpass the target level which often resort to interest rate hikes. For instance, in 2022, the FED aggressively raised interest rates to curb rapidly rising inflation, exerting pressure on financial markets.

Hawkish Policy Example

Inflation rates had surged beyond expectations due to the economic recovery following the COVID-19 pandemic and disruptions in supply chains. In response, the FED initiated an aggressive cycle of rate hikes, which emphasized the need to address unchecked inflation to maintain economic stability.

During this period, the FED increased interest rates from near-zero levels to over 4% within just a few months. This rapid hike caused volatility in financial markets. Investors, faced with higher borrowing costs and responded with selling pressure in stock markets.

The sharp rise in interest rates also dampened consumer spending and investment, putting a strain on economic growth. Mortgage rates, in particular, rose rapidly, leading to a slowdown in the housing market. This increase in home loan rates throughout 2022 reduced purchasing power and created challenges for the real estate sector.

In currency markets, the FED’s hawkish policies strengthened the US dollar against other currencies. The dollar's appreciation placed pressure on emerging market currencies, increasing costs in global trade and disrupting economic balances in those countries. Additionally, this period saw fluctuations in global commodity prices, including energy.

Effects of Hawkish Policies

• Hawkish policies involve increasing interest rates. Higher interest rates reduce consumer spending and corporate investments, thereby decreasing demand and controlling inflation.
• Central banks may halt or reverse bond purchase programs to limit the money supply in the market. This action reduces liquidity in the financial system.
• These policies are favored when inflation is viewed as a more threat than economic growth. Price stability becomes the primary goal under such an approach.
• Higher interest rates and restricted liquidity slow down economic growth, reducing demand-driven inflation.

Advantages/Disadvantages of Hawkish Policy

Advantages:

• Helps control inflation by reducing demand.
• Attracts foreign investments through interest rate hikes, strengthening the currency.
• Prevents excessive borrowing and speculative bubbles.
• Prioritizes price stability, contributing to a more sustainable economic structure.

Disadvantages:

• Reduces consumer spending and corporate investments, putting pressure on economic growth.
• Slowing economy can lead to increased unemployment rates.
• Increases selling pressure on stocks and other risky assets.
• High interest rates lower demand for mortgages and car loans, causing a contraction in these sectors.
• Rising interest rates can lead to capital outflows from developing countries, negatively impacting their economies.

What is Dovish Monetary Policy?

Dovish monetary policy refers to a central bank's approach to adopting an accommodative stance aimed at supporting economic growth and increasing employment. This approach is typically implemented during periods of low inflation or economic stagnation.

Dovish Monetary Policy Example

One example is the response to the 2008 global financial crisis. The crisis led to a severe economic downturn worldwide, and the U.S. economy was significantly affected. During this period, the Federal Reserve (FED) adopted a strong dovish monetary policy to help the economy recover and reduce unemployment.

As part of this approach, the FED swiftly lowered interest rates to a range of 0-0.25%. This policy aimed to reduce borrowing costs for banks and inject more liquidity into the market.

The FED sent strong signals that interest rates would remain at low levels for an extended period. This communication helped foster a sense of stability and encouraged consumer spending and investment activity.

To further ensure liquidity in the markets, the FED initiated large-scale asset purchases, including government bonds and mortgage-backed securities. These actions were designed to reduce financial market stress and push long-term interest rates even lower.

The expansionary policies gradually helped the U.S. economy recover. Over the years, unemployment rates declined, and job creation increased. The low-interest environment and ample liquidity drove investors toward equities, resulting in significant market growth. Indexes like the S&P 500 and Dow Jones entered a major bull market from 2009 onward.

By 2015, signs of economic recovery had strengthened in the U.S. As a result, the FED began to shift away from its dovish stance by gradually increasing interest rates. However, this transition was carried out in a cautious and measured manner.

Effects of Dovish Policies

• Central banks lower interest rates to reduce borrowing costs and encourage consumer spending. This can particularly increase demand for long-term loans such as mortgages and auto loans.
• By reducing borrowing costs for businesses, dovish policies can improve profitability and lead investors to favor equities over other asset classes.
• Dovish policies often result in the depreciation of the country's currency. While this can stimulate exports, it may also increase the cost of imports.
• Prolonged dovish policies carry the risk of inflation spiraling out of control. Therefore, central banks adopt a balanced approach when implementing such measures.

Advantages/Disadvantages of Dovish Approach

Advantages:

• Reduces interest rates, increasing consumer spending.
• Lowers borrowing costs for businesses, encouraging investment.
• Supports economic growth and reduces unemployment.
• Depreciation of the currency can increase exports.

Disadvantages:

• May increase inflation risk in the long term.
• Currency depreciation can raise import costs.
• Excess liquidity might lead to speculative bubbles.
• Low interest rates can discourage savings.

Hawkish vs Dovish: What are the Differences?

Who Decides Monetary Policy?

Monetary policy refers to the management of tools used to ensure a country's economic stability, control inflation, reduce unemployment, and support economic growth. The responsibility for determining and implementing these policies typically lies with the country's central bank.

The decision-making processes of central banks are generally carried out by specific committees. For example, the Federal Open Market Committee (FOMC) of the Federal Reserve (FED) or the Governing Council of the European Central Bank (ECB) are responsible for setting interest rates, organizing bond purchase programs, and shaping other market-related policies.

The tools used in determining monetary policy include setting interest rates, adjusting market liquidity, and regulating reserve requirements. Central banks use these tools to achieve their objectives, such as supporting economic growth or keeping inflation under control.

Why Would the FED Take a Hawkish Stance?

The FED may adopt a hawkish stance to ensure economic stability and support long-term growth. Such a policy is typically preferred when high inflation threatens economic balance.

The main reasons for the FED's hawkish policies can be summarized as follows:

• Inflation exceeding the target level and threatening price stability.
• The economy is growing rapidly, leading to demand surpassing supply.
• Strengthening the US dollar to attract foreign investments and gain a competitive advantage in international trade.
• Preventing excessive valuations in asset classes like housing, stocks, or other financial instruments.
• Raising interest rates to mitigate the pressure on the financial system caused by high borrowing levels.

Why Would the FED Take a Dovish Stance?

Dovish policy typically involves lowering interest rates, providing more liquidity to the markets, and implementing expansionary monetary policies. The primary reason for adopting a dovish stance is to stimulate economic activity and prevent bottlenecks in financial markets.

The reasons why the FED might adopt a dovish stance include the following:

• Inflation remains below the target level or there is a risk of deflation.
• To reduce unemployment and boost job creation.
• To stimulate economic activity during periods of recession.
• To encourage consumer spending by lowering borrowing costs.
• To accelerate recovery after a financial crisis.

How Do Hawkish vs Dovish Policies Affect Traders?

The decisions made by central banks when implementing these policies lead to changes in factors such as interest rates, money supply, and economic growth. This is an important factor to consider when shaping your trading strategies.

Hawkish policies generally involve raising interest rates and reducing market liquidity. This can create selling pressure on riskier assets and lead to a shift toward safer havens such as bonds and the US dollar.

The main effects of hawkish policies on traders are:

• Hawkish policies can strengthen the US dollar against other currencies.
• Rising interest rates increase borrowing costs for companies, negatively affecting their profitability and leading to declines in stock prices.
• Higher interest rates attract capital to developed markets, causing volatility in emerging markets.
• Increased interest rates raise bond yields, encouraging traders to shift from stocks to bonds.
• Dovish policies, on the other hand, are associated with lowering interest rates and increasing the money supply. These policies drive investors toward riskier assets, often resulting in upward movements in stocks, commodities, and emerging market assets.

The effects of dovish policies on traders are:

• Low interest rates drive traders toward riskier assets, supporting upward movements in stock markets.
• They can weaken the national currency against other currencies.
• Low interest rates increase demand for commodities such as gold, as non-interest-bearing assets become more attractive.

More on Hawkish and Dovish Stances

How does a hawkish stance affect currency pairs?

A hawkish stance typically signals an expectation of interest rate hikes. This increases demand for the respective country's currency, leading to its appreciation. For example, if the Federal Reserve adopts a hawkish stance, the US dollar tends to strengthen against other currencies. In currency pairs like EUR/USD, the dollar's appreciation causes the pair to decline.

How does the US dollar respond to a hawkish decision by the Federal Reserve?

A hawkish decision by the Federal Reserve implies an increase in interest rates, making the US dollar more attractive. Higher interest rates encourage traders to favor higher-yielding assets denominated in dollars. As a result, the US dollar gains power against other currencies.

How do hawkish policies impact stock markets?

Hawkish policies are often associated with higher interest rates. Increased borrowing costs can reduce corporate profitability, leading to downward pressure on stock prices. Growth-oriented companies, which are more sensitive to interest rates, are particularly affected and may experience significant value declines.

What is the impact of dovish policies on commodity prices?

Dovish policies, characterized by lower interest rates and increased liquidity, often boost commodity demand. Lower interest rates weaken the dollar. This can lead to higher prices for assets like gold and oil.

How does a dovish policy period affect safe-haven assets like gold?

Dovish policies, which lower interest rates, can weaken the dollar. A weaker dollar increases the appeal of safe-haven assets like gold, which do not offer yields. On the other hand, increased liquidity and reduced market uncertainties during dovish periods drive up demand for gold. 

How does a dovish stance impact equity indices?

A dovish stance generally has a positive effect on stock markets. Lower interest rates reduce corporate borrowing costs, boosting profitability. Additionally, a low-rate environment encourages investors to seek higher-risk assets, driving stock indices like the S&P 500 upward. Dovish policies often result in upward momentum for indices.

Can hawks become doves and vice versa?

Yes, central bankers or policymakers can shift between hawkish and dovish stances depending on economic conditions. For instance, a central banker advocating for rate hikes during inflationary periods might adopt a dovish stance during economic recessions to stimulate growth. These shifts reflect the need to adapt to changing economic dynamics.

Is it possible to be both hawkish and dovish?

While a central bank or policymaker typically leans towards one stance based on prevailing economic conditions, they can exhibit both hawkish and dovish tendencies in different contexts. For example, a central bank might focus on inflation control (hawkish) while simultaneously implementing measures to support growth (dovish), showcasing a balanced approach.