The Influence of Central Banks and Monetary Policies on the Trading Process

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The Influence of Central Banks and Monetary Policies on the Trading Process

When working on the financial market, with the aid of various trading tools, private investors must conduct complex calculations and evaluate many indicators. It is a vital component for generating forecasts for trades. The main task for any successful trader is, specifically, the questions of correctly forecasting the vectors of market movement stably. In regards to this questions, traders adopt a wide range of approaches to analysis, which can be divided generally into one of two kinds, either fundamental or technical analysis. Both formats for evaluating market data require a lot of specialized knowledge and basic understandings in terms of analyzing financial and economic signs. Once you have mastered the specific, specialized knowledge necessary, that the vast majority of private investors have, we advise you to read this article on the role of Central Banks and their policies related to the activities of traders on the financial market.

What is the Central Banks and Monetary Policy

The Central Bank of any country is the main government body that regulates the financial market and economic processes. Their task is to take specific actions to protect the country’s economy, setting normal conditions for the work of the banking sphere and also regulating the processes of the financial market. The combination of actions taken by the Central Bank within the government is referred to as monetary policy.

In essence, the central bank is the main financial market actor, and, aided by specialized approaches, can pass specific regulatory actions on it. So the Central Bank has direct levers for regulating the supply of the national currency, indicator changes based on interest rates, defining laws on the function of banking instruments within the government, as well as being able to instantly influence the financial market through interventions and their own investment activity.

Against this backdrop, central banks are no different than large governmental financial market actors with significant additional abilities for regulating the economic process. When taking into account all the levers and market regulatory tools, as well as the drivers of various assets, all the regulatory approaches can be divided into the following types and forms:

1. The following are, in turn, general monetary policy methods:

● Through regulation of the interest rate, the government is, therefore, regulating access to financial tools, as well as both private and business access to affordable loans. To put it simply, the interest rate is the basic indicator for calculating consumer credit at commercial banks. This significantly influences consumer purchasing power, economic growth and business activity, and, subsequently, the rates of financial assets that are correlated with this indicator. Interest rates most influence private traders’ trading indicators specifically, because they are a leading factor when conducting fundamental market analysis.

● In regards to setting banking norms, it is necessary to mention that the role of the central bank, as a banking industry regulator, has an incredibly high level of influence on the country’s economic process, meaning the country’s direct economic livelihood and its population. So the Central Bank can set the required reserves for commercial banks, carrying out their actions under the jurisdiction of the regulator.

● Setting and changing bank reserves opens up the opportunity to regulate access to the supply of national currency. Therefore, it is possible not only to influence the economic process but the mechanism for forming exchange rates as well. This is also a defining factor for successful trading

● The Central Bank can directly impact market activity not only as a regulator but as an active participant in financial trading and market speculation as well. When analyzing the Central Bank’s financial opportunities as an investor, you could say that the regulator meets all the requirements to actively influence the rates of specific fundamental assets. So, the vast majority of central banks of various different governments actively invest in particular currencies, gold, funds, as well as banking products. Therefore, the Central Bank brings in additional revenue to the government and receives additional resources for market regulation

2. Selected Methods

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In general, these approaches affect specific tools and types of government financial activities. In particular, the following are clear examples of this type of approach:

● The Central Bank can limit access or altogether bar banks for giving specific types of loans by regulating borrowing. This is typically done to decrease aggregate in specific economic sphere or limit banks’ access offering uninhibited and highly-liquid products.

● By change the lending conditions, besides restricting credit, the Central Bank can change regulations and the ways in which they are issued. Typically, these actions are taken to combat money laundering, decreasing the pressure on the economy, lowering inflation. Regulating access to credit is also used as a tool for limiting large global banks, in terms of governments.

We’ve gone through only several of the most basic regulatory tools available to central banks that online investors can utilize when conducting fundamental market analysis. Of course, the total list of tools and regulatory opportunities are wide and varied and include hundreds of approaches. Although all the basic forms of monetary policy previously laid out open up a wide range of trading opportunities.

When analyzing Central Bank credit policy as a factor of influence in online trading, it is necessary to point out several critical points

● First, working and learning the limitations of regulatory tools is vital when analyzing the market. This type of forecasting regime should not be used on a case-by-case basis, but on an ongoing basis. The reason for this is due to the long-term influence of fundamental regulatory tools on the financial market. Taking interest rates as an example, we can clearly point out that any Central Bank credit rate fluctuations defined by long-term national currency trends. Therefore, when analyzing the market, you must always take into account fundamental tools and monetary policy indicators.
● Second, when generating forecasts, keep in mind that the Central Bank isn’t all powerful. The issue is that excessive regulation or half-baked monetary policy can completely destroy the financial market or the country’s economy. There are a vast number of examples of this. Which is why, when working with trading tools, it is not worth relying on the aid of regulators in difficult financial situations. The Central Bank strives to be balanced in their actions, as they influence the economy long-term, so adjust medium-term trading plans in accordance with the regulatory body

In conclusion, we’d like to point out that, although the Central Banks have numerous tools of influence and shape monetary policy, the market today is more independent and self-regulating than ever. For this reason, in recent times we have seen an increase in the elasticity of the financial market when regulators have tried to manipulate it sharply, which is undoubtedly the result of the influence of private traders. However, despite that, the work of the Central Bank is a leading factor in fundamental analysis, which is vital for every investor to take into account when forming trades

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How Central Banks Control the Supply of Money

If a nation’s economy were a human body, then its heart would be the central bank. And just as the heart works to pump life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing. Sometimes economies need less money, and sometimes they need more.

The methods central banks use to control the quantity of money vary depending on the economic situation and power of the central bank. In the United States, the central bank is the Federal Reserve, often called the Fed. Other prominent central banks include the European Central Bank, Swiss National Bank, Bank of England, People’s Bank of China, and Bank of Japan.

Let’s take a look at some of the common ways that central banks control the money supply—the amount of money in circulation throughout a country.

key takeaways

  • To ensure a nation’s economy remains healthy, its central bank regulates the amount of money in circulation.
  • Influencing interest rates, printing money, and setting bank reserve requirements are all tools central banks use to control the money supply.
  • Other tactics central banks use include open market operations and quantitative easing, which involve selling or buying up government bonds and securities.

Why the Quantity of Money Matters

The quantity of money circulating in an economy affects both micro- and macroeconomic trends. At the micro-level, a large supply of free and easy money means more spending by people and by businesses. Individuals have an easier time getting personal loans, car loans, or home mortgages; companies find it easier to secure financing. too.

At the macroeconomic level, the amount of money circulating in an economy affects things like gross domestic product, overall growth, interest rates, and unemployment rates. The central banks tend to control the quantity of money in circulation to achieve economic objectives and affect monetary policy.

Once upon a time, nations pegged their currencies to a gold standard, which limited how much they could produce. But that ended by the mid-20 th century, so now, central banks can increase the amount of money in circulation by simply printing it. They can print as much money as they want, though there are consequences for doing so. Merely printing more money doesn’t affect the economic output or production levels, so the money itself becomes less valuable. Since this can cause inflation, simply printing more money isn’t the first choice of central banks.

Set the Reserve Requirement

One of the basic methods used by all central banks to control the quantity of money in an economy is the reserve requirement. As a rule, central banks mandate depository institutions (that is, commercial banks) to keep a certain amount of funds in reserve (stored in vaults or at the central bank) against the amount of deposits in their clients’ accounts. Thus a certain amount of money is always kept back and never circulates. Say the central bank has set the reserve requirement at 9%. If a commercial bank has total deposits of $100 million, it must then set aside $9 million to satisfy the reserve requirement. It can put the remaining $91 million into circulation.

When the central bank wants more money circulating into the economy, it can reduce the reserve requirement. This means the bank can lend out more money. If it wants to reduce the amount of money in the economy, it can increase the reserve requirement. This means that banks have less money to lend out and will thus be pickier about issuing loans.

Central banks periodically adjust the reserve ratios they impose on banks. In the United States (effective January 16, 2020), smaller depository institutions with net transaction accounts up to $16.9 million are exempt from maintaining a reserve. Mid-sized institutions with accounts ranging between $16.9 million and $127.5 million must set aside 3% of the liabilities as a reserve. Institutions with more than $127.5 million have a 10% reserve requirement.

On March 26, 2020, in response to coronavirus pandemic, the Fed reduced reserve requirement ratios to 0%—eliminating reserve requirements for all U.S. depository institutions, in other words.

Influence Interest Rates

In most cases, a central bank cannot directly set interest rates for loans such as mortgages, auto loans, or personal loans. However, the central bank does have certain tools to push interest rates towards desired levels. For example, the central bank holds the key to the policy rate—the rate at which commercial banks get to borrow from the central bank (in the United States, this is called the federal discount rate). When banks get to borrow from the central bank at a lower rate, they pass these savings on by reducing the cost of loans to their customers. Lower interest rates tend to increase borrowing, and this means the quantity of money in circulation increases.

Engage in Open Market Operations

Central banks affect the quantity of money in circulation by buying or selling government securities through the process known as open market operations (OMO). When a central bank is looking to increase the quantity of money in circulation, it purchases government securities from commercial banks and institutions. This frees up bank assets: They now have more cash to loan. Central banks do this sort of spending a part of an expansionary or easing monetary policy, which brings down the interest rate in the economy.

The opposite happens in a case where money needs to be removed from the system. In the United States, the Federal Reserve uses open market operations to reach a targeted federal funds rate, the interest rate at which banks and institutions lend money to each other overnight. Each lending-borrowing pair negotiates their own rate, and the average of these is the federal funds rate. The federal funds rate, in turn, affects every other interest rate. Open market operations are a widely used instrument as they are flexible, easy to use, and effective.

Introduce a Quantitative Easing Program

In dire economic times, central banks can take open market operations a step further and institute a program of quantitative easing. Under quantitative easing, central banks create money and use it to buy up assets and securities such as government bonds. This money enters into the banking system as it is received as payment for the assets purchased by the central bank. The banks’ reserves swell up by that amount, which encourages banks to give out more loans, it further helps to lower long-term interest rates and encourage investment. After the financial crisis of 2007-2008, the Bank of England, and the Federal Reserve launched quantitative easing programs. More recently, the European Central Bank and the Bank of Japan have also announced plans for quantitative easing.

The Bottom Line

Central banks work hard to ensure that a nation’s economy remains healthy. One way central banks accomplish this aim is by controlling the amount of money circulating in the economy. Their tools include influencing interest rates, setting reserve requirements, and employing open market operation tactics, among other approaches. Having the right quantity of money in circulation is crucial to ensuring a stable and sustainable economy.

Monetary Policy

What is Monetary Policy?

Monetary policy consists of the process of drafting, announcing, and implementing the plan of actions taken by the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied. Monetary policy consists of management of money supply and interest rates, aimed at achieving macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. These are achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange rates, and changing the amount of money banks are required to maintain as reserves. Some view the role of the International Monetary Fund as this.

Key Takeaways

  • Monetary policy is how a central bank or other agency governs the supply of money and interest rates in an economy in order to influence output, employment, and prices.
  • Monetary policy can be broadly classified as either expansionary or contractionary.
  • Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations (subject to the central bank’s credibility).

Monetary Policy

Understanding Monetary Policy

Economists, analysts, investors, and financial experts across the globe eagerly await the monetary policy reports and outcome of the meetings involving monetary policy decision-making. Such developments have a long lasting impact on the overall economy, as well as on specific industry sector or market.

Monetary policy is formulated based on inputs gathered from a variety of sources. For instance, the monetary authority may look at macroeconomic numbers like GDP and inflation, industry/sector-specific growth rates and associated figures, geopolitical developments in the international markets (like oil embargo or trade tariffs), concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible sources.

Monetary authorities are typically given policy mandates, to achieve stable rise in gross domestic product (GDP), maintain low rates of unemployment, and maintain foreign exchange and inflation rates in a predictable range. Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses to taxes, government borrowing, and spending to manage the economy.

The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal Reserve has what is commonly referred to as a “dual mandate”: to achieve maximum employment (with around 5 percent unemployment) and stable prices (with 2 to 3 percent inflation). It is the Fed’s responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low. Its core role is to be the lender of last resort, providing banks with liquidity and serve as a bank regulator, in order to prevent the bank failures and panics in the financial services sector.

Types of Monetary Policies

At a broad level, monetary policies are categorized as expansionary or contractionary.

If a country is facing a high unemployment rate during a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity. As a part of expansionary monetary policy, the monetary authority often lowers the interest rates through various measures that make money saving relatively unfavorable and promotes spending. It leads to an increased money supply in the market, with the hope of boosting investment and consumer spending. Lower interest rates mean that businesses and individuals can take loans on convenient terms to expand productive activities and spend more on big ticket consumer goods. An example of this expansionary approach is the low to zero interest rates maintained by many leading economies across the globe since the 2008 financial crisis. (For related reading, see “What Are Some Examples of Expansionary Monetary Policy?”)

However, increased money supply can lead to higher inflation, raising the cost of living and cost of doing business. Contractionary monetary policy, by increasing interest rates and slowing the growth of the money supply, aims to bring down inflation. This can slow economic growth and increase unemployment, but is often required to tame inflation. In the early 1980s when inflation hit record highs and was hovering in the double digit range of around 15 percent, the Federal Reserve raised its benchmark interest rate to a record 20 percent. Though the high rates resulted in a recession, it managed to bring back the inflation to the desired range of 3 to 4 percent over the next few years.

Tools to Implement Monetary Policy

Central banks use a number of tools to shape and implement monetary policy.

First is the buying and selling of short term bonds on the open market using newly created bank reserves. This is known as open market operations. Open market operations traditionally target short term interest rates such as the federal funds rate. The central bank adds money into the banking system by buying assets (or removes in by selling assets), and banks respond by loaning the money more easily at lower rates (or more dearly, at higher rates), until the central bank’s interest rate target is met. Open market operations can also target specific increases in the money supply in order to get the banks to loan funds more easily, by purchasing a specified quantity of assets; this is known as quantitative easing.

The second option used by monetary authorities is to change the interest rates and/or the required collateral that the central bank demands for emergency direct loans to banks in its role as lender-of-last-resort. In the U.S. this rate is known as the discount rate. Charging higher rates and requiring more collateral, will mean that banks have to be more cautious with their own lending or risk failure and is an example of contractionary monetary policy. Conversely, lending to banks at lower rates and at looser collateral requirements will enable banks to make riskier loans at lower rates and run with lower reserves, and is expansionary.

Authorities also use a third option, the reserve requirements, which refer to the funds that banks must retain as a proportion of the deposits made by their customers in order to ensure that they are able to meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing the reserve requirement has a reverse effect, curtailing bank lending and slowing growth of the money supply.

In addition to the standard expansionary and contractionary monetary policies, unconventional monetary policy has also gained tremendous popularity in recent times. During periods of extreme economic crisis, like the financial crisis of 2008, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities by introducing news lending and asset purchase programs that combined aspects of discount lending, open market operations, and quantitative easing. Monetary authorities of other leading economies across the globe followed suit, with the Bank of England, the European Central Bank and the Bank of Japan pursuing similar policies.

Lastly, in addition to direct influence over the money supply and bank lending environment, central banks have a powerful tool in their ability to shape market expectations by their public announcements about the central bank’s own future policies. Central banks statements and policy announcements move markets, and investors who guess right about what the central banks will do can profit handsomely. Some central bankers choose to be deliberately opaque to market participants in the belief that this will maximize the effectiveness of monetary policy shifts by making them unpredictable and not “baked-in” to market prices in advance. Others choose the opposite: to be more open and predictable in the hopes that they can shape and stabilize market expectations in order to curb volatile market swings that can result from unexpected policy shifts.

However, the policy announcements are effective only to the extent of the credibility of the authority which is responsible for drafting, announcing, and implementing the necessary measures. In an ideal world, such monetary authorities should work completely independent of influence from the government, political pressure, or any other policy-making authorities. In reality, governments across the globe may have varying levels of interference with the monetary authority’s working. It may vary from the government, judiciary, or political parties having a role limited to only appointing the key members of the authority, or may extend to forcing them to announce populist measures (to influence an approaching election for example). If a central bank announces a particular policy to put curbs on increasing inflation, the inflation may continue to remain high if common public have no or little trust in the authority. While making investment decisions based on the announced monetary policy, one should also consider the credibility of the authority.


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Monetary Policy and Central Banking

Central banks play a crucial role in ensuring economic and financial stability. They conduct monetary policy to achieve low and stable inflation. In the wake of the global financial crisis, central banks have expanded their toolkits to deal with risks to financial stability and to manage volatile exchange rates. Central banks need clear policy frameworks to achieve their objectives. Operational processes tailored to each country’s circumstances enhance the effectiveness of the central banks’ policies. The IMF supports countries around the world by providing policy advice and technical assistance.

Monetary policy

A key role of central banks is to conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations. The policy frameworks within which central banks operate have been subject to major changes over recent decades.

Since the late 1980s, inflation targeting has emerged as the leading framework for monetary policy. Central banks in Canada, the euro area, the United Kingdom, New Zealand, and elsewhere have introduced an explicit inflation target. Many low-income countries are also making a transition from targeting a monetary aggregate (a measure of the volume of money in circulation) to an inflation targeting framework.

Central banks conduct monetary policy by adjusting the supply of money, generally through open market operations. For instance, a central bank may reduce the amount of money by selling government bonds under a “sale and repurchase” agreement, thereby taking in money from commercial banks. The purpose of such open market operations is to steer short-term interest rates, which in turn influence longer-term rates and overall economic activity. In many countries, especially low-income countries, the monetary transmission mechanism is not as effective as it is in advanced economies. Before moving from monetary to inflation targeting, countries should develop a framework to enable the central bank to target short-term interest rates (paper).

Following the global financial crisis, central banks in advanced economies eased monetary policy by reducing interest rates until short-term rates came close to zero, which limited the option to cut policy rates further (i.e., limited conventional monetary options). With the danger of deflation rising, central banks undertook unconventional monetary policies, including buying long-term bonds (especially in the United States, the United Kingdom, the euro area, and Japan) with the aim of further lowering long term rates and loosening monetary conditions (paper). Some central banks even took short-term rates below zero.

Foreign exchange regimes and policies

The choice of a monetary framework is closely linked to the choice of an exchange rate regime. A country that has a fixed exchange rate will have limited scope for an independent monetary policy compared with one that has a more flexible exchange rate. Although some countries do not fix the exchange rate, they still try to manage its level, which could involve a tradeoff with the objective of price stability. A fully flexible exchange rate regime supports an effective inflation targeting framework.

Macroprudential policy

The global financial crisis showed that countries need to contain risks to the financial system as a whole with dedicated financial policies. Many central banks that also have a mandate to promote financial stability have upgraded their financial stability functions, including by establishing macroprudential policy frameworks. Macroprudential policy needs a strong institutional foundation to work effectively. Central banks are well placed to conduct macroprudential policy because they have the capacity to analyze systemic risk. In addition, they are often relatively independent and autonomous. In many countries, legislators have assigned the macroprudential mandate to the central bank or to a dedicated committee within the central bank. Regardless of the model used to implement macroprudential policy, the institutional setup should be strong enough to counter opposition from the financial industry and political pressures and to establish the legitimacy and accountability of macroprudential policy. It needs to ensure that policymakers are given clear objectives and the necessary legal powers, and to foster cooperation on the part of other supervisory and regulatory agencies (see further Key Aspects of Macroprudential Policy) . A dedicated policy process and is needed to operationalize this new policy function, by mapping an analysis of systemic vulnerabilities into macroprudential policy action (Staff Guidance Note on Macroprudential Policy).

How the IMF supports effective central bank frameworks

The IMF promotes effective central bank frameworks through multilateral surveillance, policy papers and research, bilateral dialogue with its member countries, and the collection of data for policy analysis and research.

Multilateral surveillance, policy analysis and research can help improve global outcomes:

The IMF has provided policy advice on how to avoid potential side effects from the implementation of and exit from unconventional monetary policy (paper), and established principles for evolving monetary policy regimes in low income countries (paper).

The Fund has also examined interactions between monetary and macroprudential policy (paper), and provided principles for the establishment of well-functioning macroprudential frameworks (guidance note).

The IMF is in regular dialogue with member country central banks through bilateral surveillance (Article IV consultation), FSAPs and technical assistance:

In its Article IV consultations, the IMF provides advice on monetary policy action to achieve low and stable inflation, as well as on establishing effective monetary policy and macroprudential policy frameworks.

The Financial Sector Assessment Program (FSAP) provides member countries with an evaluation of their financial systems and in-depth advice on policy frameworks to contain and manage financial stability risks, including the macroprudential policy framework, which is now often covered in dedicated technical notes (see for example Finland, Netherlands, and Romania).

Country programs supported by an IMF arrangement often include measures to strengthen monetary policy and central bank governance.

Technical assistance helps countries develop more effective institutions, legal frameworks, and capacity. Topics include monetary policy frameworks, exchange rate regimes, moving from targeting a monetary aggregate to inflation targeting, improving central bank operations (such as open market operations and foreign exchange management), and macroprudential policy implementation.

In order to inform policy development and research, the IMF is also engaged with its members to develop and maintain databases:

The IMF has for some time kept track of countries’ monetary policy arrangements (AREAER), as well as central banks’ legal frameworks (CBLD), and their monetary operations and instruments (MOID).

The IMF has recently launched a new annual survey of macroprudential measures and institutions. This survey will support IMF advice and policymakers around the world, by providing details on the design of macroprudential measures, and enabling comparisons across countries and over time

The IMF also compiled a comprehensive historical database of macroprudential measures (iMaPP) that integrates the latest survey information and allows for an assessment of the quantitative effects of macroprudential instruments (paper). This database is now being used by IMF economists to measure policy effects, and it is also available to researchers around the world.

How Central Banks Impact the Forex Market

The role of central banks in the forex market

Central banks are mainly responsible for maintaining inflation in the interest of sustainable economic growth while contributing to the overall stability of the financial system. When central banks deem it necessary they will intervene in financial markets in line with the defined “Monetary Policy Framework”. The implementation of such policy is highly monitored and anticipated by forex traders seeking to take advantage of resulting currency movements.

This article focuses on the roles of the major central banks and how their policies affect the global forex market.

What is a central bank?

Central Banks are independent institutions utilized by nations around the world to assist in managing their commercial banking industry, set central bank interest rates and promote financial stability throughout the country.

Central banks intervene in the financial market by making use of the following:

  • Open market operations : Open market operations (OMO) describes the process whereby governments buy and sell government securities (bonds) in the open market, with the aim of expanding or contracting the amount of money in the banking system.
  • The central bank rate : The central bank rate, often referred to as the discount, or federal funds rate, is set by the monetary policy committee with the intention of increasing or decreasing economic activity. This may seem counter-intuitive, but an overheating economy leads to inflation and this is what central banks aim to maintain at a moderate level.

Central banks also act as a lender of last resort. If a government has a modest debt to GDP ratio and fails to raise money through a bond auction, the central bank can lend money to the government to meet its temporary liquidity shortage.

Having a central bank as the lender of last resort increases investor confidence. Investors are more at ease that governments will meet their debt obligations and this heps to lower government borrowing costs.

FX traders can monitor central bank announcements via the central bank calendar

Major central banks

Federal Reserve Bank (United States)

The Federal Reserve Bank or “The Fed” presides over the most widely traded currency in the world according to the Triennial Central Bank Survey, 2020. Actions of The Fed have implications not only for the US dollar but for other currencies as well, which is why actions of the bank are observed with great interest. The Fed targets stable prices, maximum sustainable employment and moderate long-term interest rates.

European Central Bank (European Union)

The European central bank (ECB) is like no other in that it serves as the central bank for all member states in the European Union. The ECB prioritizes safeguarding the value of the Euro and maintaining price stability. The Euro is the second most circulated currency in the world and therefore, generates close attention by forex traders.

Bank of England

The Bank of England operates as the UK’s central bank and has two objectives: monetary stability and financial stability. The UK operates using a Twin Peaks model when regulating the financial industry with the one “peak” being the Financial Conduct Authority (FCA) and the other the Prudential Regulating Authority (PRA). The Bank of England prudentially regulates financial services by requiring such firms to hold sufficient capital and have adequate risk controls in place.

The Bank of Japan has prioritized price stability and stable operations of payment and settlement systems. The Bank of Japan has held interest rates below zero (negative interest rates) in a drastic attempt to revitalize the economy. Negative interest rates allow individuals to get paid to borrow money, but investors are disincentivised to deposit funds as this will incur a charge.

Central bank responsibilities

Central banks have been established to fulfil a mandate in order to serve the public interest. While responsibilities may differ between countries, the main responsibilities include the following:

1) Achieve and maintain price stability : Central banks are tasked with protecting the value of their currency. This is done by maintaining a modest level of inflation in the economy.

2) Promoting financial system stability : Central banks subject commercial banks to a series of stress testing to reduce systemic risk in the financial sector.

3) Fostering balanced and sustainable growth in an economy : In general, there are two main avenues in which a country can stimulate its economy. These are through Fiscal policy (government spending) or monetary policy ( central bank intervention ). When governments have exhausted their budgets, central banks are still able to initiate monetary policy in an attempt to stimulate the economy.

4) Supervising and regulating financial institutions : Central banks are tasked with the duty of regulating and supervising commercial banks in the public interest.

5) Minimize unemployment : Apart from price stability and sustainable growth, central banks may have an interest in minimising unemployment. This is one of the goals from 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, emanate from this base rate. The central bank interest rate is the interest rate that is charged to commercial banks looking to borrow money from the central bank on an overnight basis.

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

Commercial banks need to borrow funds from the central bank in order to comply with a modern form of banking called Fractional Reserve Banking. Banks accept deposits and make loans meaning they need to ensure that there is sufficient cash to service daily withdrawals, while lending the rest of depositors’ money to businesses and other investors that require cash. The bank generates revenue through this process by charging a higher interest rate on loans while paying lower rates to depositors.

Central banks will define the specific percentage of all depositors’ funds (reserve) that banks are required to set aside, and should the bank fall short of this, it can borrow from the central bank at the overnight rate, which is based on the annual central bank interest rate.

FX traders monitor central bank rates closely as they can have a significant impact on the forex market. Institutions and investors tend to follow yields (interest rates) and therefore, changes in these rates will result in traders channelling investment towards countries with higher interest rates.

How central banks impact the forex market

Forex traders often assess the language used by the chairman of the central bank to look for clues on whether the central bank is likely to increase or decrease interest rates. Language that is interpreted to suggest an increase/decrease in rates is referred to as Hawkish/Dovish . These subtle clues are referred to as “forward guidance” and have the potential to move the forex market.

Traders that believe the central bank is about to embark on an interest rate hiking cycle will place a long trade in favour of that currency, while traders anticipating a dovish stance from the central bank will look to short the currency.

For more information on this mechanism, read, “ Interest Rates and the Forex Market ”

Movements in central bank interest rates present traders with opportunities to trade based on the interest rate differential between two country’s currencies via a carry trade . Carry traders look to receive overnight interest for trading a high yielding currency against a low yielding currency.

Learn more about forex fundamentals

  • DailyFX provides a dedicated central bank calendar showing all the scheduled central bank rate announcements for major central banks.
  • Keep up to date with crucial central bank announcements or data releases happening this week via our economic calendar .
  • Data releases have the ability to make significant moves in the FX market but with increased volatility, it is important to manage your risk accordingly by learning how to trade the news .
  • To learn more about forex trading and get your foot in the door of successful trading, download our free New to Forex guide .

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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