CENTRAL BANKS’ ROLE IN THE FOREX MARKET
In order to promote long-term economic development and contribute to the general stability of the financial system, central banks are primarily responsible for managing inflation. When required, central banks will act in the financial markets in accordance with the established “Monetary Policy Framework.” Since they want to profit from the ensuing currency swings, forex traders closely watch and anticipate the adoption of such policies.
The major central banks’ functions and the ways in which their policies impact the world’s FX market are the main topics of this essay.
WHAT IS CENTRAL BANK?
Central banks are autonomous organizations that are used by countries all over the globe to help manage their commercial banking sector, determine central bank interest rates, and advance financial stability throughout the nation.
The following are some strategies used by central banks to interfere in the financial market:
- Open market operations (OMO): The process by which governments purchase and sell government securities (bonds) on the open market with the intention of increasing or decreasing the quantity of money in the banking system is referred to as open market operations (OMO).
- The central bank rate: The central bank rate, also known as the discount rate or the federal funds rate, is set by the monetary policy committee with the purpose of stimulating or lowering economic activity. Although it may seem counterintuitive, central banks try to keep inflation at a modest level since it is a direct result of an overheated economy.
Additionally, central banks serve as lenders of last resort. If a government fails to obtain money via a bond auction and has a moderate debt to GDP ratio, the central bank may be able to lend the government money to make up for its short-term liquidity constraint.
Investor trust is raised when a central bank serves as the lender of last resort. Because investors are increasingly confident that governments would honor their debt commitments, the cost of government borrowing has decreased.
PRIMARY CENTRAL BANKS
- Federal Reserve Bank (United States)
According to the 2016 Triennial Central Bank Survey, “The Fed” is in charge of the currency that is exchanged the most globally. The Fed’s decisions affect not just the US dollar but also other currencies, which is why people pay close attention to what it does. The Fed aims for stable prices, the highest level of sustainably growing employment, and moderate long-term interest rates.
- The European Central Bank (European Union)
Being the central bank for every member state of the European Union makes the European Central Bank (ECB) unique. Securing the value of the Euro and preserving price stability are priorities for the ECB. Since the Euro is the second most widely used currency worldwide, forex traders pay careful attention to it.
- The Bank of England
As the UK’s central bank, the Bank of England has two goals: monetary stability and financial stability. When it comes to overseeing the financial sector, the UK uses a Twin Peaks model, with the Financial Conduct Authority (FCA) as one “peak” and the Prudential Regulating Authority as the other (PRA). By mandating that these companies maintain sufficient capital and implement proper risk controls, the Bank of England prudentially supervises the financial services industry.
- The Bank of Japan
The Bank of Japan has placed a high priority on maintaining stable prices and reliable payment and settlement systems. In a bold effort to jump-start the economy, the Bank of Japan has kept interest rates at or below zero (negative interest rates). People can borrow money for free because to negative interest rates, but investors are less likely to deposit money since doing so would result in fees.
RESPONSIBILITIES OF THE CENTRAL BANK
The purpose of central banks’ establishment is to carry out a mandate in the public interest. Despite the fact that duties may vary by nation, the following are the principal ones:
1) Achieve and maintain price stability: The job of central banks is to preserve the value of their nation’s currency. This is accomplished by keeping the economy’s inflation rate moderate.
2) Encouraging the stability of the financial system: To lower systemic risk in the financial sector, central banks subject commercial banks to a series of stress tests.
3) Promoting balanced and long-term economic growth: There are generally two basic ways for a nation to boost its economy. These are accomplished by monetary policy or fiscal policy (government expenditure) (central bank intervention). Central banks may still start monetary policy to try to boost the economy even after governments have spent all of their money.
4) Monitoring and controlling financial institutions: In the public’s best interest, central banks have the responsibility of monitoring and controlling commercial banks.
5) Reduce unemployment: In addition to promoting price stability and sustained economic expansion, central banks could be motivated to reduce unemployment. This is one of the Federal Reserve’s objectives.
INTEREST RATES AND CENTRAL BANKS
All other interest rates that people encounter on personal loans, mortgages, credit cards, and other types of loans are derived from the base rate established by central banks. The interest rate levied by the central bank to commercial banks seeking overnight credit is known as the central bank interest rate.
The next graph illustrates this impact of central bank interest rates by showing how commercial banks charge customers a higher rate than the one they may negotiate with the central bank.
A contemporary kind of banking known as fractional reserve banking requires commercial banks to borrow money from the central bank. Banks take deposits and issue loans, so they must make sure there is enough money on hand to cover daily withdrawals while lending the remaining funds from depositors to companies and other investors who need cash. Through this strategy, the bank makes money by charging a higher interest rate on loans while giving depositors lesser rates.
If a bank falls short of the reserve requirement, it may borrow money from the central bank at the overnight rate, which is based on the annual central bank interest rate. Central banks will specify the precise proportion of depositor funds (reserve) that banks must hold aside.
Since central bank rates may significantly affect the currency market, FX traders regularly follow them. Since institutions and investors often monitor yields (interest rates), changes in these rates will cause traders to direct capital toward nations with higher interest rates.
WHAT IMPACT CENTRAL BANKS HAVE ON THE FOREX MARKET
Forex traders often analyze the central bank chairman’s rhetoric to determine if the central bank is going to raise or lower interest rates. Hawkish and Dovish terms relate to language that is taken to imply a rise or drop in rates. Known as “ahead guidance,” these imperceptible cues have the power to influence the FX market.
Traders who think the central bank is poised to start raising interest rates will put a long bet in that currency’s favor, while those who believe the central bank will take a dovish position would attempt to short the currency.
Changes in central bank interest rates provide traders the chance to engage in a carry trade based on the interest rate difference between the currencies of two nations. Carry traders trade a high yielding currency against a low yielding currency in an effort to earn overnight interest.