No matter where you live, your country’s monetary system is heavily influenced by the central bank, and actions taken by the central bank are likely to have a significant impact on the economy – and in particular on the foreign exchange market. . If you are a trader, you should probably be aware of these dynamics, especially today in 2022 when state intervention in monetary systems has become so commonplace, mainly due to the pandemic.
It is now convenient to trade Forex, as brokers like INFINOX offer attractive trading costs, fast trade execution, and plenty of currency pairs to get involved in. Understanding how central banks influence rates is therefore an important part of the process, especially when it comes to fundamental analysis.
Central banks influence the foreign exchange market
Control the money supply
Basically, central banks are responsible for controlling the amount of money available (or not available). They do this by raising or lowering interest rates. Simply put, when rates are low, the price of money is low, prompting banks, businesses and the general public to take out new loans. The money supply increases, which decreases the purchasing power of the currency, so the currency weakens against other peers.
Money supply and impact on currency pairs
In the opposite scenario, the increase in rates no longer encourages borrowing and, as old loans mature, in the absence of new ones, the money supply contracts. That could happen this year as the BoE and Federal Reserve are expected to continue raising interest rates.
You should also know that some central banks, especially those in emerging markets, intervene in the foreign exchange market to prevent exchange rates from weakening or appreciating too much. A currency that is too strong can harm exporters while favoring importers, and in the case of a currency that is too weak, the exact opposite applies.
Analysts from leading trading brand INFINOX point out that traders should monitor central bank news and announcements, as such interventions typically produce strong price movements. These are not the kind of situations in which one would like to be taken on the wrong foot.
No central bank wants volatility in the currency space, which is why they provide forward guidance to markets, which means they communicate with the public about expected policies. By doing so, you have more predictability as to how things may change in the future. Changes in short-term interest rates and asset purchases (which are usually done to suppress long-term rates) influence risk sentiment, so you should be aware that currencies can fluctuate when such changes occur. produce.
Tightening monetary policy is a difficult process, mainly because it has a deflationary effect. You can see central banks these days changing stance, but at a moderate pace, as they aim not to create solvency risks, or weaken the already fragile economic recovery.
Is the forex market too big to control?
You might also wonder why central banks can control a market that accounts for over $6 trillion in daily trading volumes. In some situations, their actions may have limited influence, but it’s how banks and financial institutions react to what central banks do that essentially pushes markets in one direction or another.
Trading central bank monetary policy decisions can be tricky, especially if you’re a beginner and still need to develop some trading skills. This is why it is sometimes better to wait and see how the market digests the news, and only then to look for trading opportunities.
This article does not necessarily reflect the views of the editors or management of EconoTimes