A Central Bank is considered to be the supreme monetary authority of a country – or group of countries as in the case of the Euro Zone – and plays a vital role in the economic health of any country. Its different actions affect every asset class, including the FOREX market. What are the main functions and objectives of a Central Bank? What tools are used to reach its goals? What are the effects on the FOREX market?

Importance of Central Banks on the FOREX market

What are the main functions of a Central Bank?

A Central Bank is, first of all, the institution that provides money by ensuring the issuance of paper money, and also by monitoring that commercial banks have the ability to create bank money.

Central Banks are thus the guarantor of bank liquidity and banking system stability, and set up monetary policy that controls the money supply, hence the importance of Central Banks on the FOREX market. To prevent financial panics from “bank runs” spreading, Central Banks are also the lender of last resort (LOLR) to provide liquidity if there is an increased demand for liquidity that cannot be met from other sources.

A Money Authority is responsible for the implementation of the monetary policy in a country, which represents all the decisions taken by a Central Bank to influence the cost and the availability of money in a given economy. Monetary policy, in association with fiscal policy, is part of the economic policy of a country, and their combination (policy-mix) mainly influences growth, consumption, employment, inflation and the country currency.

What are the main Central Bank tools used to reach its objectives?

Central Banks have different objectives written in their status – one can focus on the exchange rate, on inflation, on aggregate monetary growth, on employment etc. But, for most of them, their main objective is to stabilize the nation’s currency and control inflation, as well as to keep unemployment low while maximising economic development.

Central Banks conduct monetary policy by acting either on the amount of money in the economy, or by acting on its price. Central Banks can change the amount of money in the economy mainly by changing interest rates or reserve requirements.

The level of “reserve requirements” represents the portion of deposits that banks must hold in cash, in their vaults or at the Central Bank. A decrease in the level of reserve requirements is expansionary, because it increases the funds available in the banking system for loans to consumers and businesses, while an increase in reserve requirements is more restrictive.

Central banks may also seek to influence the price of Central Bank money with interest rates. They can define a target for interest rates on the money market or through open market operations. Different types of operations are classified in this category and are not the same in every country, but it’s always when Central Banks buy or sell securities from the country’s banks or financial institutions to add or remove cash from the economy, which has an influence on the FOREX market.

Central Banks are a key player on the FOREX market

Among the major economic players, Central Banks have a prominent role in the evolution of different currencies. As Central Banks have the task of controlling the money supply and maintain economic stability, their decisions (monetary policy) directly influence currencies, because they decide on interest rates, which in turn influence the attraction of a currency for foreigner investors. Key interest rates will then be reflected in other interest rates charged by banks for loans (student loans, car loans, commercial loans…), which will have an impact on the money spent by individuals and businesses.

Thus, higher interest rates will attract foreign investors, which will result in an increased demand for the currency of the country, and therefore a strengthening of the currency against other currencies. Also, higher interest rates will increase borrowing costs, and money availability on markets will diminish, and the value of a currency should then increase.

With an expansionary monetary policy, there is an increase in the monetary base and lower interest rates. With more cash available for banks and in the market, the value of various financial assets increases. So, this excess supply of funds will create a significant flow of a currency on markets, which will dilute the value of this currency. With lower interest rates, it’s easier to borrow money and this will tend to decrease the value of the money.

What to expect as a FOREX trader?

As we said in a previous article: “investors’ expectations with respect to monetary policy decisions (easing or tightening) will have an impact on a currency” and “Monetary policy differences between countries are thus an important driver in the evolution of currencies, because it is this rate differential that will make a currency more (or less) profitable for an investor”.

Another reason for you to be aware of the different key interest rates while investing on the FOREX market is because of currency carry trade that produces real cash flows.

In conclusion, as a FOREX trader, you cannot invest on currencies without following Central Banks meetings and decisions that can affect the amount of money in a given economy. You can also expect higher volatility during those announcements that could be useful for you, especially if you’re trading news.

More than just those decisions, you need to follow any news that can give you useful information about the health of a given economy or how close from its objectives their Central Bank is: mainly data about employment, consumption, growth and inflation.

Example: the American dollar

The FED increased its main interest rate of 25 basis point (Fed Funds range at 0.25%-0.50%) in December 2015, for the 1^st time since the financial crisis. The Dollar Index had increased before this decision, as the market was expecting this rate hike.

In the wake of the decision, the USD lost momentum and went down, as the FED highlighted the fact that they will “gradually” increase interest rates depending on economic data being released. Investors’ expectations about other rate hikes then diminished and the value of the American dollar decreased, because FED members are undecided about the rate hikes schedule.

Happy Trading!