How Central Banks Impact the Forex Market

The Role of Central Banks in the Foreign Exchange Market

Central banks are primarily responsible for maintaining inflation to ensure sustainable economic growth while contributing to the overall stability of the financial system. When deemed necessary, they intervene in the financial market in accordance with a predetermined “Monetary Policy Framework.” The implementation of this policy is closely monitored and anticipated by foreign exchange traders, who seek to capitalize on subsequent currency fluctuations.

This article focuses on the role of major central banks and how their policies impact the global foreign exchange market.

What is a Central Bank?

Central banks are independent institutions utilized by countries worldwide to help manage the commercial banking sector, set central bank interest rates, and promote financial stability within the nation.

Central banks intervene in financial markets using the following tools:

Open Market Operations: Open Market Operations (OMO) describes the process of governments buying and selling government securities (bonds) on the open market, aiming to expand or contract the amount of money in the banking system.

Central Bank Interest Rates: The central bank interest rate, often referred to as the discount rate or the federal funds rate, is set by the monetary policy committee with the aim of increasing or decreasing economic activity. This may seem counterintuitive, but an overheating economy will lead to inflation, which central banks aim to maintain at moderate levels.

Central banks also act as lenders of last resort. If a government has a moderate debt-to-GDP ratio and is unable to raise money through bond auctions, the central bank can lend money to the government to meet its temporary liquidity shortages.

Having a central bank as a lender of last resort increases investor confidence. Investors are more assured that governments will meet their debt obligations, which helps to reduce the government’s borrowing costs.

Key Central Banks

Federal Reserve Bank (United States)

The Federal Reserve Bank (Fed) manages the most widely traded currency globally, according to the 2016 Triennial Central Bank Survey. The Fed’s actions not only impact the US Dollar but also other currencies, making its decisions closely watched. The Fed targets price stability, maximum sustainable employment, and moderate long-term interest rates.

European Central Bank (European Union)

The European Central Bank (ECB) is unique in its role as the central bank for all member states of the European Union. The ECB prioritizes safeguarding the value of the Euro and maintaining price stability. The Euro is the second most circulated currency globally, thus attracting significant attention from forex traders.

Bank of England

The Bank of England (BoE) serves as the central bank of the United Kingdom with two goals: monetary stability and financial stability. The UK operates under a Twin Peaks model for financial regulation, with one “peak” being the Financial Conduct Authority (FCA) and the other the Prudential Regulation Authority (PRA). The BoE prudently regulates financial services by requiring these firms to hold sufficient capital and have adequate risk controls.

Bank of Japan

Responsibilities of a Central Bank

Central banks are established to serve the public interest. While responsibilities can vary across countries, the key responsibilities include the following:

Achieving and maintaining price stability: Central banks are tasked with protecting the value of their domestic currency. This is achieved by maintaining moderate inflation levels in the economy.

Promoting financial system stability: Central banks test the resilience of commercial banks to reduce systemic risk in the financial sector.

Promoting balanced and sustainable growth in the economy: Generally, there are two main avenues a country can use to stimulate its economy. These are through fiscal policy (government spending) or monetary policy (central bank intervention). When governments have exhausted their budgets, central banks can still initiate monetary policy to try and stimulate the economy.

Supervising and regulating financial institutions: Central banks are tasked with regulating and supervising commercial banks for the public good.

Minimizing unemployment: In addition to price stability and sustainable growth, central banks may be concerned with minimizing unemployment. This is one of the goals of the Federal Reserve.

Central Banks and Interest Rates

Central banks set the central bank interest rate, and all other interest rates that individuals experience on personal loans, home loans, credit cards, etc., are derived from this base rate. The central bank interest rate is the interest charged to commercial banks that want to borrow money from the central bank overnight.

This influence of the central bank interest rate is depicted below, with commercial banks charging individuals a higher interest rate than the rate they can secure with the central bank.

Commercial banks need to borrow money from the central bank to comply with the modern form of banking known as Fractional Reserve Banking. Banks accept deposits and make loans, meaning they need to ensure that there is enough cash on hand to service daily withdrawals, while lending the rest of the deposits to businesses and other investors who need cash. Banks generate revenue through this process by charging higher interest rates on loans while paying lower interest rates to depositors.

Central banks will determine the specific percentage of all deposits (reserves) that banks are required to set aside, and if banks fail to meet this level, they can borrow from the central bank at the overnight rate, based on the annual central bank interest rate.

Forex traders closely monitor central bank interest rates because they can have a significant impact on the foreign exchange market. Institutions and investors tend to follow yield (interest rates), and therefore changes in these rates will result in traders moving investments to countries with higher interest rates.

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