You’ve heard of them everywhere.
No matter what newspaper you pick, you will see it…
The Federal Reserve (FED) increased interest rates, or…
The European Central Bank (ECB) increased its monetary stimulus…
And the list goes on.
Why are these events so important?
Why are investors so interested in Central Bank moves?
And ultimately, how does this affect you, as a retail trader?
Let’s go on.
As usual, we start by making sure we are on the same page.
A Central Bank is the one institution with the power to bring new bills into an economy.
They print the money (technically, some print money elsewhere, but you get the point).
Each country or region (as in the Eurozone) has one Central Bank in charge of the country’s currency.
We’re talking about all of the money, including deposits, not just physical cash.
Whatever you have in your bank account, or your wallet… be it a dollar, a euro, or anything else…
It was introduced and is being regulated by the Central Bank in charge of that currency.
Since most of the world’s transactions are done in United States Dollars (USD), the Central Bank of the United States (The Federal Reserve) is the most influential and followed Central Bank in the world.
It is followed closely by the Central Banks of other powerful economies such as Europe, Japan, and the United Kingdom.
As the sole authority over the amount of money, the Central Bank has tremendous power over the fate of the economy.
Let’s think about it this way.
To buy anything, you need money.
But everyone needs money.
If a Central Bank reduces the amount of money circulating, people will have less money with which to transact.
Retail and commercial banks will have fewer deposits with which to loan.
Which means, to lend money, a bank will require a higher interest rate.
This is why interest rates are usually seen as “the price of money”.
But wait a second, if suddenly there are fewer dollars for everyone out there….
Yes, the dollar will gain value against other currencies (all else equal).
Which means, the Central Bank affected exchange rates and therefore, directly impacted your forex trade.
How exactly do they do it?
And is there a method to this madness?
Central Banks have several instruments with which they can increase or decrease money supply.
To simplify things, let’s focus on a simple example.
Let’s say the FED has decided the economy is booming and inflation (general increase in prices) may set in.
In order to avoid inflation from getting out of hand, the FED realizes it needs to increase interest rates.
Because higher interest rates will make loans more expensive, which in turn, makes major capital investments more expensive.
If investments become more expensive (because capital is more expensive), then aggregate investment in the economy will fall.
The fall of investment will decrease price pressure (inflation pressure) in the economy since there will be fewer buyers driving prices up.
But how does the FED increase interest rates in the first place?
Well, let’s think of two separate things:
The FED, and the rest of the world
Any dollar the FED has, is a dollar the rest of the world doesn’t.
Similarly, every dollar out there in the world is a dollar not in possession of the FED.
So now that we’ve established this dichotomy, how can the FED increase interest rates?
If you’ve been paying attention, you’ll know they do it by decreasing money supply.
Money supply is the amount of dollars out in the world.
Ok, so how do they suck-up those dollars?
I thought you would never ask.
The FED engages in what’s called open market operations.
They buy and sell securities.
What does this mean?
Think of it this way.
When you buy a bond, the seller gets the money and you get the bond, right?
Well, the FED can sell bonds and get cash in return.
When they do this, that cash is no longer out in the world, it is in the FED’s control.
As such, money supply has decreased and the interest rate-investment mechanism already discussed kicks in.
And as we mentioned in the last section, this change in money supply will pressure exchange rates in the forex market (demand and supply baby).
Now you know the basics of Central Bank economics.
Things in the real world are never as simple, but the example above more or less sums up how things work.
Every Central Bank out there in one way or another decreases (or increases) money supply to accomplish their mandate.
All of this takes us to the million dollar question, how on earth do I use Central Bank moves to make money trading forex?
To decipher their moves we have to know what they’re after.
Most Central Banks have the mandate to preserve economic stability by maintaining price stability.
In the case of the FED, it also has the mandate to maintain economic growth around its potential.
Dude you’re just talking rubbish, tell me what this means!
Ok, in general, Central Banks care about any signs of inflation.
If an economic indicator predicts a higher (or lower) than expected level of inflation, a Central Bank is much more likely to take action to correct the situation (which in turn, has a predictable effect on currency markets, all else equal).
With the FED though, it’s more complicated than that.
Given its dual mandate, the FED also keeps an eye on growth. And they usually do so by keeping an eye on employment.
This is why there’s so much fuss about US unemployment and the labor indicators which are released so frequently.
Too little unemployment might be a sign of the economy overheating, while too much unemployment is a sign of a weak economy.
Either way, the FED is more likely to intervene.
Of course, everyone would be a multimillionaire if things were so simple.
What are the wrinkles?
The FED or any other Central Bank may not act based on reports. This is why it’s important to know what they are paying attention to at the time.
For example, employment may be important this month, but not the next.
Also, since we’re trading currencies, there are two Central Banks behind each pair.
What happens if both Central Banks are doing the same with their money supply?
It isn’t clear which currency will appreciate, and thus, the direction of your trade won’t be clear.
This is why it’s useful to look for divergent monetary policies (when one bank increases supply while the other decreases it).
That way, you increase the chance that the currency pair will move in the direction predicted by the forces of supply and demand.
This has been a long page, but I’m sure it’s left some useful information for those who aren’t already forex fundamental analysis hacks.
Either way, you’re best served by delving deeper into understanding Central Banks and their influence in currency markets.
You will be glad you did (or got someone who can do it for you).
See you soon,
The Forex EconomistHome > Forex Economics > Central Banks
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