The policies of Central banks play a leading role in forex trading as they reflect the economic stability of a country and shape its future economic growth. The major objective for all Central Banks’ decisions is balancing between inflation rates, steady economic growth, and relative currency stability. To achieve these mandates, banks are required to set policies in order to support the economy towards targets. In the last few years, several surprising Central Bank decisions from around the world sent shockwaves through the markets, illustrating clearly the different ways that these decisions can affect forex trading.
Central banks can affect market prices on a massive scale. So, you need to closely monitor the policy paths of central banks with many traders basing their positions on their announcements. How frequently they are likely to change and the potential direction they will go in are crucial in trading decisions.
What is a Central Bank?
A central bank is a financial institution that sets the monetary system for a nation. Central banks are given privileged authority to issue currency, function as the bank of the government, manage exchange reserves, regulate the credit system, oversee commercial banks and act as a lender of last resort. Central banks have a defined range of responsibilities that includes overseeing monetary policy and implementing specific tools to achieve main mandates such as currency stability, steady inflation and full employment.
Some central banks have a single mandate which is price stability, such as the European Central Bank. Others have dual policy mandates; price stability and employment, like the Federal Reserve and Reserve Bank of New Zealand.
Which Central Banks Affect the Forex Market?
Top Central Banks that affect forex prices are the banks of the most traded currencies. The eight major central banks are:
- The Federal Reserve – FED
- The European Central Bank – ECB,
- Bank of England – BoE
- Bank of Japan – BoJ
- Reserve Bank of Australia – RBA
- Reserve Bank of New Zealand – RBNZ
- Bank of Canada – BoC
- Swiss National Bank -SNB.
Altogether, these eight banks control the currencies of the major forex pairs. The Federal Reserve Bank is the top influential bank as approximately 90% of all currency transactions include the US Dollar, which is also the top reserve currency in the world.
Policies of Central Banks
Monetary policies are divided into two main categories; expansionary monetary policies and contractionary monetary policies. Both involve controlling the level of the money supply in a country to maintain steady and sustainable economic growth.
Expansionary monetary policy is simply aimed to increase the supply of money, while contractionary monetary policy works on decreasing currency supply to curb demand. A neutral monetary policy intends to neither create growth nor fight inflation.
To achieve their policy mandates, central banks use monetary tools mainly to control the interest rates, inflation levels, money supply, lending to commercial banks, and reserve requirements.
Central Banks and Interest Rates
Interest rates are the primary influencer of investment flows. Central banks set interest rates applied to businesses and individuals.
Central Banks tend to raise interest rates to curb high inflation and an overheating economy. This is because high-interest rates mean people and businesses will borrow and spend less. These policies aim to prevent the economy from growing too fast which can create economic bubbles.
However, after expansionary cycles, hiking interest rates can be a good sign that the economy is growing.
On the contrary, when an economy is shrinking, interest rates are lowered as the central bank wants people to borrow and spend more. Lower interest rates encourage more people to borrow and spend, therefore stimulating the economy. When the central bank considers lowering interest rates, it means that the economy is not doing well which leads traders to sell that currency. And when lowering the interest rate isn’t efficient enough to revive the economy, the central bank may start quantitative easing.
Trading Central Banks Decisions
Forex traders tend to interpret announcements by central banks based on their tone, language, and forward guidance to forecast future steps. Policy announcements usually hint whether they will cut, hike or hold interest rates.
- Hawkish Tone: It is seen as a positive tone, where a central bank starts to consider tightening policy and hike interest rates in wake of a better economic outlook.
- Dovish Tone: It is seen as a negative tone, as the central bank considers taking expansionary measures and cutting interest rates to fight economic downturns.
Typically, intending to hike interest rates or maintain neutral levels is good for the currency. In contrast to when a central bank intends to cut interest rates or maintain high levels.
However, announcements do not guarantee actual changes but can be a good opportunity to seize the trend that follows outlook change. That said, the future direction of interest rates matters the most as the current rate is already priced in.
Consider current interest rates, but most importantly interpret announcements to know where rates are going, and the currency will follow. It is also important to note how frequently a central bank holds its meetings. Some are more frequent than others, which can offer more trading opportunities. Sometimes a central bank will announce surprise interest rate changes, which cannot always be predicted and can have a significant effect on the forex market.
So, How Central Banks affect your Trading Decisions?
Usually higher interest rates lead to currency appreciation, especially when it is backed by solid economic conditions and steady growth. Currencies tend to depreciate affected by lower interest rates and expansionary monetary measures applied by central banks. Central bank’s decisions have a direct impact on price directions in the forex market. Make sure to follow the changes in central banks’ language for better trading decisions.
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