How Forex Market is Affected by Central Banks

THE FUNCTION OF CENTRAL BANKS IN THE FOREX MARKET

Central banks are mainly in charge of controlling inflation in the interest of sustainable economic growth while contributing to the overall stability of the financial system. When central banks find it necessary they will intervene in financial markets according to the defined “Monetary Policy Framework”. The execution of such policy is highly watched and expected by forex traders looking to take advantage of resulting currency movements.

This article explains the roles of the major central banks and how their policies affect the global forex market.

WHAT IS A CENTRAL BANK?

Central Banks are independent institutions used by countries around the world to help in managing their commercial banking industry, set central bank interest rates and promote financial stability throughout the country.

Central banks intervene in the financial market by using the following:

• Open market operations: Open market operations (OMO) refer to the process whereby governments buy and sell government securities (bonds) in the open market, with the goal of increasing or decreasing the amount of money in the banking system.
• The central bank rate: The central bank rate, often called the discount, or federal funds rate, is determined by the monetary policy committee with the intention of stimulating or slowing down economic activity. This may seem counter-intuitive, but a booming economy leads to inflation and this is what central banks aim to keep at a moderate level.

Central banks also act as a lender of last resort. If a government has a low debt to GDP ratio and fails to raise money through a bond auction, the central bank can lend money to the government to meet its temporary liquidity shortage.

Having a central bank as the lender of last resort boosts investor confidence. Investors are more comfortable that governments will meet their debt obligations and this helps to lower government borrowing costs.

Foreign exchange traders can observe central bank pronouncements using the monetary authority schedule.

MAJOR CENTRAL BANKS

FEDERAL RESERVE BANK (UNITED STATES)

The Federal Reserve Bank, colloquially known as "The Fed," governs the preeminent globally exchanged currency, as affirmed by the Triennial Central Bank Survey in 2016. The Fed's decisions carry ramifications not solely for the US dollar, but also for other currencies, engendering fervent scrutiny. The bank's primary objectives encompass maintaining price stability, fostering optimal sustainable employment, and cultivating judicious long-term interest rates.

EUROPEAN CENTRAL BANK (EUROPEAN UNION)

The European central bank (ECB) stands unparalleled, for it assumes the mantle of the singular central bank for all member states within the European Union. The paramount mission of the ECB lies in safeguarding the unequivocal value of the Euro while diligently upholding steadfast price stability. As the Euro garners recognition as the world's second most circulated currency, it becomes a focal point of unyielding interest for the discerning forex traders.

BANK OF ENGLAND

The Bank of England serves as the United Kingdom's central bank, with a distinctive focus on ensuring both monetary stability and financial stability. The UK implements a Twin Peaks model to oversee the financial industry, consisting of two primary regulatory bodies: the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). The Bank of England exercises prudential oversight over financial services by mandating firms to maintain ample capital reserves and implement robust risk management measures.

JAPAN

The Bank of Japan has placed utmost importance on ensuring price stability and the smooth functioning of payment and settlement systems. In a bold and radical move to rejuvenate the economy, the Bank of Japan has opted to keep interest rates below zero, implementing negative interest rates. This unconventional measure permits individuals to receive payments for borrowing money, yet it dissuades investors from depositing their funds as they would face a penalty.

THE ROLE OF CENTRAL BANKS

Central banks are public institutions that have been created to fulfil a certain mission for the common good. Their responsibilities may vary across countries, but they usually include the following:

• Maintain and achieve price stability: Central banks aim to preserve the purchasing power of their currency. This is done by keeping inflation at a low and stable level in the economy.
• Support financial system stability: Central banks conduct regular stress tests on commercial banks to reduce the risk of financial crises.
• Encourage balanced and sustainable growth in an economy: Generally, there are two main ways to stimulate an economy. These are through fiscal policy (government spending) or monetary policy (central bank action). When governments run out of budget, central banks can still use monetary policy to boost the economy.
• Regulate and supervise financial institutions: Central banks have the duty of overseeing and regulating commercial banks in the public interest.
• Reduce unemployment: Besides price stability and sustainable growth, central banks may also have an interest in reducing unemployment. This is one of the objectives of the Federal Reserve.

CENTRAL BANKS AND INTEREST RATES

Central banks determine the central bank interest rate, which is the basis for all other interest rates that individuals face on personal loans, home loans, credit cards etc. The central bank interest rate is the interest rate that commercial banks pay to borrow money from the central bank overnight.

The effect of central bank interest rates is shown below with the commercial banks charging a higher rate to individuals than the rate they get from the central bank.

Commercial banks rely on borrowing funds from the central bank to adhere to the modern banking system known as Fractional Reserve Banking. By accepting deposits and granting loans, they must ensure sufficient cash reserves to meet daily withdrawals while lending the remaining funds to businesses and investors in need of capital. This process allows banks to generate revenue by charging higher interest rates on loans while offering lower rates to depositors.

Central banks establish a specific percentage of all depositors' funds that banks must maintain as reserves. If a bank falls short of this requirement, it can borrow from the central bank at the overnight rate, determined by the annual central bank interest rate.

Foreign exchange (FX) traders closely monitor central bank rates as they can exert a significant influence on the forex market. Institutional investors tend to follow yields (interest rates), and consequently, fluctuations in these rates prompt traders to direct their investments toward countries with higher interest rates.

THE INFLUENCE OF CENTRAL BANKS ON THE FOREX MARKET

Forex traders often analyse the words used by the head of the central bank to look for hints on whether the central bank is likely to raise or lower interest rates. Words that are interpreted to imply a rise/fall in rates are called Hawkish/Dovish. These subtle signals are called “forward guidance” and have the power to move the forex market.

Traders that expect the central bank to start an interest rate increasing cycle will place a long trade in favour of that currency, while traders anticipating a dovish attitude from the central bank will look to short the currency. Changes in central bank interest rates offer traders opportunities to trade based on the interest rate difference between two country’s currencies via a carry trade. Carry traders look to earn overnight interest for trading a high yielding currency against a low yielding currency.

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