How Central Banks Influence Forex prices
A Central Bank is an independent national authority whose main aim is to stabilize a nation’s currency, keep the unemployment levels low and to maintain the inflation levels for sustainable economic growth. The Central Banks assist the nations in managing their commercial banking industry by setting the commercial banks interest rates and thus, promoting financial stability throughout the country. The central banks step in the financial markets by making use of Open Market Operations i.e., When Central Banks buy and sell Government Securities (bonds) in the open markets with the aim of enhancing or contracting the liquidity in the banking system, and by setting the central bank rate with the help of monetary policy committee in view of maintaining the inflation rates in the economy. Central banks play an important role of Lender of last resort as they lend money to the government to meet its temporary liquidity shortage which enhances the investors confidence. Name of some familiar central banks of various nations like Federal Reserve bank of United States, European Central Bank of European Union, Bank of England of United Kingdom and Bank of Japan. The main responsibilities of a central bank include protecting the value of their currency by maintaining the modest level of inflation in the economy. Along with it, promoting the financial system stability by subjecting the central to a series of stress testing to reduce systematic risk in financial sector.
Forex Traders monitor closely the central bank rates as these have a significant impact on the forex market. The Institutional Investors as well as Retail Investors follow closely the changes in interest rates as these interest rate changes give a direction to traders in channelizing their investments towards countries with higher interest rates. Forex traders often look for the clues in the language used the chairman of federal bank so as to decode whether central bank is to increase or decrease the interest rates. These clues are referred to as “Forward Guidance” and have the capacity to move the forex markets. If the traders believe the central bank is going to hike the interest rates, then they will place a long trade in the favour of that currency while the traders anticipating reduction in interest rates will favour a short trade for that currency. The Variations or movements in the interest rates of the central banks provide traders with the opportunity to trade based on the interest rate difference between the currency of two countries.