11.3 The Role of Central Banks in Forex

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Understanding Central Banks - Text Version

In the previous lesson, we talked about key economic data as a cornerstone of fundamental analysis in Forex, including interest rates. In this lesson, we are going to look at the role of central banks, and how their decisions regarding a country’s wider monetary policy, and not just the interest rate, can be used as a very important element of fundamental analysis.

So, what are central banks? Every country has a bank, run to some extent by the government, which is at the top of its national banking system. The central bank will determine and implement a monetary policy, which includes not only the rate of interest at which they will lend to lower banks, but also whether to increase or reduce the money supply. National currencies are only debt, after all, and supply of the currency can be expanded or reduced at the touch of a button by a central bank using a few different tools. For example, you might have heard of “quantitative easing”, which is just a fancy phrase for a bank effectively increasing the money supply by buying its own bonds.

Most central banks release a written statement once each month along with their decision on interest rates, and they often give a press conference also where the head of the bank will take questions from journalists. These statements, both written and oral, are closely scrutinized by the market, because even the presence or an absence of a single word can change perceptions of the bank’s monetary policy going forward.

What does this mean for fundamental analysts? Essentially, the key question is whether a central bank is pursuing a “hawkish” (sometimes called “tight”) or “dovish” (often called “accommodative” or “loose”) monetary policy. A hawkish policy means higher interest rates and a restriction of the money supply – these will tend to increase the relative value of a country’s currency. A dovish policy means lower interest rates and an expansion of the money supply – these will tend to decrease the relative value of a currency. This is supply and demand 101! Rates may even be reduced below zero to negative, and we have seen this in recent years in the Eurozone, Japan, and Switzerland.

Sometimes a moment arrives when a central bank makes it clear they are switching decisively from a hawkish to a dovish policy, although the process of change is usually deliberately more gradual. When these moments arrive, they can cause major multi-month trend reversals in a currency, which may run for thousands of pips.

So, all you need to do as a fundamental analyst is work out whether a central bank’s policy is more hawkish, more dovish, or neutral, and watch the policy announcements for any changes. Then compare this to the market’s expectations. If the market expects a bank to announce a more hawkish policy and it does, this is much less of a big deal than if the change is relatively unexpected!

Now, keeping track of monetary policy might complex and intimidating. If you watch the media after these releases, you will hear economists arguing about the exact meaning of single words or phrases in the Bank’s statement! Relax – you don’t have to work it all out yourself or get too tangled up in the policy details. All you need to know is:

1)      the broad outline of a bank’s policy,

2)       in which direction it is changing (if at all), and

3)      whether its latest announcement has surprised the market.

That is ALL you really need to know, and you can use major news sources to find out this information. Sure, pundits will always disagree to some extent, but it really doesn’t have to be rocket science.

Of course, the more you can understand about WHY central banks pursue certain policies, the better to give you a more complete picture. Central banks are usually trying to maintain stability by making small changes to policy at just the right time. Most central banks have as their key task the maintenance of price stability – which means keeping the rate of inflation within a predetermined target range. Usually, a higher rate of interest will dampen inflation. However, when an economy is in recession, a central bank will see there is little danger of inflation, and they will try to inject some adrenaline into the economy by means of a low interest rate. This is a good example of how major economic data releases and central bank policies can affect each other.

Now we’ve covered the impact of central banks, in the next and final lesson in this course, we will look at how to bring all these elements together into an analysis, and how to use fundamental analysis in your Forex trading.