Every second of every day, trillions change hands in the shadows of global finance, most of which does not happen on a trading floor but rather with silent algorithms and the quiet power of central banks pulling the strings. Most people know that central banks are responsible for regulating a nation’s monetary policy.
Every country has its own central bank (or its own version of one), like the Federal Reserve (US), the European Central Bank (ECB), the Bank of Japan (BOJ), and the Monetary Authority of Singapore (MAS), among others. However, not many people know these banks have far-reaching implications on the forex market.
To help you understand, we explore the roles central banks play in the forex market and how their policies influence currency trading. The aim is to understand the connection between central banks and forex so that you can make informed trading decisions.
Understanding Central Banks
Around the world, central banks are the financial institutions responsible for managing a country’s currency, money supply, and interest rates. Regardless of their country, they usually have a similar set of objectives.
Most of these objectives revolve around ensuring economic stability, controlling inflation, maintaining a decent employment rate, and providing financial security to their citizens. Plus, every central bank aims to keep its currency competitive in the global market.
These banks make monetary policy decisions to ensure that they achieve these objectives, and these decisions are among the most critical events in major financial markets worldwide, especially in the forex market.
That’s why traders often rely on tools and advanced trading platforms that can help them navigate the effects of said policy decisions and changes.
For example, traders in Singapore might use MetaTrader 4 Singapore to get real-time price tracking of major currency pairs affected by central bank policies and technical and fundamental analysis tools to interpret central bank-driven market trends.
Central Banks’ Tools To Influence Forex Trading
Central banks have significant power over how well economies worldwide perform, arguably more than any entity, and to perform their duties effectively, central banks have a few vital tools at their disposal.
These tools are different from the ones that governments use. Typically, governments rely on legislation and regulation; central banks operate with different instruments that allow them to influence the money supply, interest rates, and overall financial conditions, ultimately shaping economic activity, which would directly impact the forex trading market.
Here are some of the key tools they employ:
1. Interest Rate Control
The most significant tool in a central bank’s monetary policy arsenal is its ability to adjust interest rates to control inflation and stimulate economic growth. There are a few ways that these can be used:
Rate Hikes
There are many reasons why central banks may increase interest rates, but the most direct one is to combat inflation. Experts agree that an increase in interest rates lowers inflation because borrowing becomes more expensive. An increased interest rate can also attract foreign investments due to higher returns, which can increase demand for the country’s currency, strengthening its value.
Rate Cuts
Lowering interest or policy rates encourages borrowing and spending and can stimulate the economy, but it can also weaken the currency due to reduced foreign investor interest.
Unique Approaches
Some central banks, like the Monetary Authority of Singapore (MAS), do not use interest rates to manage their economy. Instead, the Singapore dollar (SGD) is controlled through an exchange rate system, adjusting its value against a trade-weighted basket of currencies.
It periodically adjusts this band to maintain price stability and economic competitiveness, ensuring Singapore’s export-driven economy remains stable.
2. Quantitative Easing (QE)
When interest rates hit rock bottom and traditional monetary policies are not as effective, central banks tend to turn to a process that is considered to be a bit unconventional and quite risky: quantitative easing.
Essentially, it works by electronically creating new money and using said money to purchase large amounts of assets, usually government bonds but also corporate bonds and mortgage-backed securities.
Why do central banks do this?
The simple answer is that they do so to inject enough liquidity into the financial system, lower long-term interest rates, and encourage investment and lending. As borrowing becomes cheaper, businesses expand, consumers spend more, and the overall economy gets a much-needed boost.
However, doing this runs a big risk of causing currency devaluation, which can lead to inflation due to an overheating economy. In reality, QE has proven effective in times of crisis, such as the 2008 financial meltdown. However, its long-term consequences remain a subject of debate among economists.
3. Direct Currency Intervention
In cases of extreme volatility or in times when there is a need to maintain trade competitiveness, central banks can decide to directly intervene in the forex market by buying or selling their own currency to influence exchange rates. Here’s what that might look like:
- When a central bank wants to strengthen its currency, it buys its own currency in the foreign exchange market. This increases demand for the currency, which can lead to its appreciation.
- On the other hand, a central bank sells its own currency in the foreign exchange market when it wants to weaken its own currency.
This is significant to foreign exchange traders because, in the short term, direct intervention can impact exchange rates, especially if it is an unexpected change. However, the long-term effectiveness of direct intervention is often limited, particularly if consistent economic policies do not support it.
N.B., these tools are usually on the radar of traders who want to be successful in the currency market because they drive significant fluctuations in currency pairs.
Why Central Banks Matter to Forex Traders
Central banks wield powerful influence over currency fluctuations, making their policies essential to any forex trading strategy.
With that in mind, it’s important to note that a monetary policy change from one central bank can affect the value of foreign exchange assets. This is why successful forex traders always watch news from the central banks of the currencies they trade.
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