If there is one thing a forex trader must learn early on in their career, it is that central banks can have a huge effect on the movements of a currency pair. In today’s markets, that is even more the case, since the world’s central banks have taken a leading role in rescuing the global economy from the financial crisis in 2008.
The most important central bank is undoubtedly the Federal Reserve, chaired by Janet Yellen. Other important central banks include the European Central Bank (ECB), the Bank of England (BOE) and the Bank of Japan (BOJ). There’s also the Bank of China, Reserve Bank of Australia, and the Bank of Canada.
A central bank’s mandate is usually to spur on economic growth while keeping a lid on inflation and it can do so in a number of ways.
Guest post by FXTM
Setting interest rates
The principal way a central bank can affect markets is by setting interest rates and they can be the most important factors affecting the direction of currency movements.
When a bank cuts interest rates, it does so using an open market operation and effectively puts more money into the economy in order to drive down the cost of borrowing. That causes a currency to lose value, since it ignites inflation and increases the global supply of that currency. Similarly, when a bank raises rates, the currency tends to appreciate.
On occasion, central banks may look for other ways to drive economic growth. In recent times, this has been because central banks have already cut interest rates to low levels.
QE involves another open market operation but this time the central bank purchases market assets such as bonds in order to inject more liquidity into the system. It has a similar effect to cutting interest rates in that increasing QE increases money supply and is therefore a bearish sign for the currency in question.
One crucial aspect to learning about financial markets is that it does not always matter what action a central bank takes place. What matters most is the expectations from the market. Because, if the market already expects a central bank to cut interest rates, the market will barely react when it does so.
It’s for this reason that is important to study the words and comments of central bank policymakers. For many financial journalists this is a big part of their jobs.
If a central bank official hints at a possible future rate cut or hike, that can send markets buzzing and cause major price moves. That’s why central bank announcements, press conferences and meeting minutes are given so much attention by traders and analysts.
Further reading: 5 Most Predictable Currency PairsGet the 5 most predictable currency pairs