How Central Banks Impact the Forex Market

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Central bank essential for forex market stability

The role of central banks in the forex market

Central banks are primarily responsible for keeping inflation in favor of sustainable economic growth, contributing to the overall stability of the financial system. When central banks deem it necessary, they will intervene in financial markets in accordance with the defined “Monetary Policy Framework”. The implementation of such a policy is highly monitored and anticipated by forex traders looking 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 used by nations around the world to help manage their commercial banking industry, set up central bank interest rates and promote financial stability across the country.

Central banks intervene in the financial market using the following:

  • Open market operations: Open market operations (OMO) describes the process by which governments buy and sell government securities (bonds) in the free 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 called the discount, or federal rate, is set by the monetary policy committee with the intention of increasing or decreasing economic activity. This may seem counterintuitive, but an overheated economy is leading to inflation and this is where central banks aim to keep at a moderate level.

Central banks also act as a lender of last resort. If a government has a modest debt to MEP proportion and fails to raise money through a bond auction, the central bank may lend money to the government to fill its temporary liquid shortage.

Having a central bank as a lender of last resort increases the confidence of investors. Investors find it easier for governments to meet their debt obligations, and that reduces government borrowing costs.

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

Major central banks

Federal Reserve Bank (United States)

US flag representing the US central bank

La Federal Reserve Bank or “The Fed” presides over the most widely traded currency in the world according to the 2016 Central Bank Survey, 2016. The Fed’s actions have implications not only for the US dollar but also for other currencies, so actions of the bank are observed with great interest. The Fed is targeting stable prices, maximum sustainable employment and moderate long-term interest rates.

European Central Bank (European Union)

European Union flag representing the European Central Bank

La European Central Bank (ECB) is like no other, as it serves as the central bank for all member states in the European Union. The ECB has a priority to protect the value of the euro and maintain price stability. The Euro is the second most circulated currency in the world and therefore generates close attention from forex traders.

Bank of England

English flag representing the Bank of England

La Bank of England operates as the central bank of the United Kingdom and has two objectives: monetary stability and financial stability. The UK operates on a Twin Peaks model when regulating the financial industry with this “top” being the Financial Conduct Authority (FCA) and the other Prudential Regulating Authority (PRA). The Bank of England prudently regulates financial services by requiring such firms to hold sufficient capital and to have adequate risk controls.

Bank of Japan

Japanese flag representing the Bank of Japan

La Bank of Japan prioritized price stability and stable operations of payment and regulation systems. The Bank of Japan has kept interest rates below zero (negative interest rates) in a drastic attempt to revitalize the economy. Negative interest rates allow individuals to be paid to borrow money, but investors are discouraged from depositing funds because that will pay off.

Responsibilities of a central bank

Central banks were established to fulfill a mandate to serve the general interest. Although responsibilities may differ between countries, the main responsibilities include the following:

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

2) Promote stability of financial system: Central banks are subjecting commercial banks to a series of stress tests to reduce ubiquitous risk in the financial sector.

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

4) Supervise and regulate financial institutions: Central banks have the task of regulating and controlling commercial banks in the public interest.

5) Minimize unemployment: In addition to price stability and sustainable growth, central banks may have an interest in minimizing unemployment. This is one of the goals of the Federal Reserve.

Central Banks and interest rates

Central banks set the interest rate of a central bank, and all other interest rates that individuals experience on personal loans, home loans, credit cards, etc., come out of this base rate. The central bank interest rate is the interest rate charged to commercial banks that seek to borrow money from the central bank all of a sudden.

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

FX rates from a central bank filter the system

Commercial banks need to borrow funds from the central bank to perform a modern form of banking called Fractional Reserve Banking. Banks accept deposits and give loans meaning they need to make sure there is enough money to serve daily withdrawals, lending the rest of the money from depositors to businesses and other investors who need money. The bank generates revenue through this process by charging a higher interest rate on loans by paying lower rates to depositors.

Central banks will set the specific percentage of all funds (reserve) of depositors that banks have to reserve, and if the bank is absent, it can borrow from the central bank at the overnight rate, which is based on the annual central bank interest rate.

FX traders control the rates of a central bank closely as they can have a major impact on the forex market. Institutions and investors tend to follow yields (interest rates) and therefore, changes in these rates will result in traders channeling investments to countries with higher interest rates.

How central banks affect the forex market

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

Traders who believe that the central bank will soon start an interest rate will make a long trade in favor of that currency, while traders anticipating a bearish attitude of the central bank will seek to shorten the currency.

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

Movements in central bank interest rates present to traders opportunities to trade based on the interest rate differential between two country currencies by a to carry on business. Carry traders are looking to get overnight interest due to trading high quality currency against low quality currency.

Learn more about forex fundamentals

  • DailyFX provides dedicated central bank calendar showing all scheduled central bank rate announcements for major central banks.
  • Stay up-to-date on key central bank announcements or data releases taking place this week via nia economic calendar.
  • Data releases have the ability to make significant moves in the FX market, but with increased volatility, it matters manage your risk therefore by learning how to exchange the news.
  • To learn more about forex trading and get your foot in the door of successful trading, download our free New in Forex guide.



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