Central banks are mainly responsible for maintaining inflation in the
interest of sustainable economic growth while contributing to the
overall stability of the financial system. When central banks deem it
necessary they will intervene in financial markets in line with the
defined “Monetary Policy Framework”. The implementation of such policy
is highly monitored and anticipated by forex traders seeking to take
advantage of resulting currency movements.To get more news about
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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 utilized by nations around
the world to assist in managing their commercial banking industry, set
central bank interest rates and promote financial stability throughout
the country.
Central banks intervene in the financial market by making use of the following:
Open market operations: Open market operations (OMO) describes the
process whereby governments buy and sell government securities (bonds)
in the open 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 referred to as the
discount, or federal funds rate, is set by the monetary policy
committee with the intention of increasing or decreasing economic
activity. This may seem counter-intuitive, but an overheating economy
leads to inflation and this is what central banks aim to maintain at a
moderate level.
Central banks also act as a lender of last resort. If a government has
a modest debt to GDP ratio and fails to raise money through a bond
auction, the central bank can lend money to the government to meet its
temporary liquidity shortage.
Having a central bank as the lender of last resort increases investor
confidence. Investors are more at ease that governments will meet their
debt obligations and this heps to lower government borrowing costs. The
Federal Reserve Bank or “The Fed” presides over the most widely traded
currency in the world according to the Triennial Central Bank Survey,
2016. Actions of The Fed have implications not only for the US dollar
but for other currencies as well, which is why actions of the bank are
observed with great interest. The Fed targets stable prices, maximum
sustainable employment and moderate long-term interest rates.
The European central bank (ECB) is like no other in that it serves as
the central bank for all member states in the European Union. The ECB
prioritizes safeguarding the value of the Euro and maintaining price
stability. The Euro is the second most circulated currency in the world
and therefore, generates close attention by forex traders.
The Bank of England operates as the UKs central bank and has two
objectives: monetary stability and financial stability. The UK operates
using a Twin Peaks model when regulating the financial industry with the
one “peak” being the Financial Conduct Authority (FCA) and the other
the Prudential Regulating Authority (PRA). The Bank of England
prudentially regulates financial services by requiring such firms to
hold sufficient capital and have adequate risk controls in place.
The Bank of Japan has prioritized price stability and stable
operations of payment and settlement systems. The Bank of Japan has held
interest rates below zero (negative interest rates) in a drastic
attempt to revitalize the economy. Negative interest rates allow
individuals to get paid to borrow money, but investors are
disincentivised to deposit funds as this will incur a charge.
Central banks have been established to fulfil a mandate in order to
serve the public interest. While responsibilities may differ between
countries, the main responsibilities include the following:
1) Achieve and maintain price stability: Central banks are tasked with
protecting the value of their currency. This is done by maintaining a
modest level of inflation in the economy.
2) Promoting financial system stability: Central banks subject
commercial banks to a series of stress testing to reduce systemic risk
in the financial sector.
3) Fostering balanced and sustainable growth in an economy: In
general, there are two main avenues in which a country can stimulate its
economy. These are through Fiscal policy (government spending) or
monetary policy (central bank intervention). When governments have
exhausted their budgets, central banks are still able to initiate
monetary policy in an attempt to stimulate the economy.
4) Supervising and regulating financial institutions: Central banks
are tasked with the duty of regulating and supervising commercial banks
in the public interest.
5) Minimize unemployment: Apart from price stability and sustainable
growth, central banks may have an interest in minimising unemployment.
This is one of the goals from the Federal Reserve.
CENTRAL BANKS AND INTEREST RATES
Central banks set the central bank interest rate, and all other
interest rates that individuals experience on personal loans, home
loans, credit cards etc, emanate from this base rate. The central bank
interest rate is the interest rate that is charged to commercial banks
looking to borrow money from the central bank on an overnight basis.
This effect of central bank interest rates is depicted below with the
commercial banks charging a higher rate to individuals than the rate
they can secure with the central bank.
Commercial banks need to borrow funds from the central bank in order to
comply with a modern form of banking called Fractional Reserve Banking.
Banks accept deposits and make loans meaning they need to ensure that
there is sufficient cash to service daily withdrawals, while lending the
rest of depositors money to businesses and other investors that require
cash. The bank generates revenue through this process by charging a
higher interest rate on loans while paying lower rates to depositors.
Central banks will define the specific percentage of all depositors
funds (reserve) that banks are required to set aside, and should the
bank fall short of this, it can borrow from the central bank at the
overnight rate, which is based on the annual central bank interest rate.
FX traders monitor central bank rates closely as they can have a
significant impact on the forex market. Institutions and investors tend
to follow yields (interest rates) and therefore, changes in these rates
will result in traders channelling investment towards countries with
higher interest rates.
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