The Role of Central Banks in Foreign Exchange Market

Daffa Zaky |

There are many different ways to trade on the Forex market from technical analysis, fundamental analysis, automated systems and signal providers but the reasons behind why the market moves remain the same. Although the currency market moves in what might appear to be an erratic pattern when you look at the reasons the market has moved it becomes clear. The biggest underlying reason is the monetary policy of the central bank that the base currency is related to.

When you trade forex, you trade one currency against another so in effect you are trading a push, pull situation. Very rarely do central banks release monetary policy information at the same time, so it is easy to assume that the currency pair will move dependent on the information being released from a particular central bank.

It is the central banks' job to control a countries economy through monetary policy; if the economy is moving slowly or going backward, there are steps the central bank can take to boost the economy. These steps, whether they are asset purchases or printing more money, all involve injecting more cash into the economy. The simple supply and demand economic projection occur and currency will devalue.

When the opposite occurs, and the economy is growing, the central bank will use various methods to keep that growth steady and in-line with other economic factors such as wages and prices. Whatever the central bank do or in fact don't do will affect the currency of that country. Sometimes it is within the central banks' interest to purposefully effect the value of a currency. For example, if the economy is heavily reliant on exports and their currency value becomes too high importers of that countries commodities will seek cheaper supply; hence directly effecting the economy.



Central Banks Impacts That Affect Foreign Exchange Market

Interest Rates

If the economy is doing well, the central bank will eventually hike interest rates. When this happens or when it is talked about by the central bank, you will see the value of that currency rise. Investors will shift their assets to that currency to gain better returns.

Employment Situation

Decreases in employment will result in a slow economy and eventually the decrease of interest rates having the opposite effect of an interest rate hike.

Trade Balance

The smaller the trade deficit of a country the stronger the currency will be. However, a weaker currency will result if the deficit increases as currency will be sold off commercially.

Gross Domestic Product (GDP)

GDP is the prime indicator of a countries economy. If the GDP is good then this will be a pre-empt of higher interest rates to come hence a higher currency value.

If you follow the central bank and the policies they are putting in place to keep the economy stable you will always know which direction that currency should be moving in. As previously mentioned you will always get corrections in these prices which will cause pull backs on the overall trend. This is not a change in policy and as long as nothing fundamentally had changed the price will return to what we call the fair price (the price it reached when recent information was released by the central bank).


Major Central banks that their policies are worthy noticing in forex trading


1. U.S. Federal Reserve

The U.S. Federal Reserve is regarded as one of the most influential central banks all over the world. We all know that the USD is one of the most traded currencies in forex trading, which has a great influence on the whole forex market. Thus, the role of the U.S. Federal Reserve is unparalleled in forex trading, and the policies of it can create profound influence on the forex market. A great number of experienced traders choose to pay extra attention to the movements of the Federal Open Market Committee, which is a group within the U.S. Federal Reserve. This group has a say in the policies of interest rate in forex trading.

2. Bank of England

Another major central bank that traders need to know to do forex trading successfully is Bank of England, the bank of the United Kingdom. It is the UK's equivalent of the Federal Reserve in the United States. The Bank of England has a wide range of responsibilities; for example, it acts as the government's bank; it issues currency and supervises monetary policies. Traders who want to do forex trading successfully should keep a watchful eye on the policies of this bank. The Bank of England tries to keep prices stable and to maintain confidence in the currency. Thus, it has an inflation target of 2%; the central bank tends to take actions to curb inflation when it goes above that level and to boost inflation when the level is far below 2%.

3. European Central Bank

Another major central bank that forex traders need to pay attention is the ECB in forex trading. It is accountable for the monetary operation of the EU and also the euro currency. The specific responsibilities of the ECB formulate the monetary policies, direct a foreign exchange, authorize the issuance of bank notes and hold currency reserves, etc. The council consists of the six members of the executive board of the ECB, plus the governors of all country central banks from the 12 euro area countries to formulate monetary policies.

4. Bank of Japan

The main responsibilities of the bank are to issue and handle currency and treasury securities, implement monetary policies, maintain the stability of the Japanese financial system and provide settling and clearing services. This one, like most others, does economic research and analysis and gets economic data, which is quite helpful in forex trading.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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