Intro
Central banks are key players in foreign exchange (forex) markets, as their interest rate policies and interventions have a significant impact on a currency's value. They are responsible for determining the exchange rate regimes in which a nation’s currency is traded on the forex market.
Central banks are national entities and form part of a nation’s government but act independently of them in most countries. A central bank's main responsibilities include setting interest rates, managing foreign currency reserves, maintaining banking system stability, and intervening in the forex market when necessary. All these actions can influence the value of a currency to a very large extent and therefore these measures are crucial in forex trading.
The essence
- Central banks are key players in forex markets as their policy actions can have a significant impact on a currency's value
- A central bank's main responsibilities include setting interest rates, managing foreign currency reserves, maintaining the value of a currency
- The policies and actions of some central banks have international significance
- Forex traders pay close attention to central bank decisions, announcements as these have a meaningful impact on currency exchange rates
How do central banks influence the forex market?
Most policy measures and actions taken by a central bank will have an impact on the value of the currency they oversee.
Setting interest rates
One of the main responsibilities of a central bank is to set interest rates. Deciding the level of interest rates (also called borrowing costs) is a fundamental element of a central bank’s monetary policy. Interest rates play a key role in determining how much one currency will be worth relative to another. For example, if a central bank decides to increase the interest rate, it will likely cause the value of its currency to increase, as investors and traders will buy that currency in search of higher returns. On the other hand, if a central bank lowers interest rates, its currency could depreciate as investors seek higher returns elsewhere.
If a central bank keeps lowering interest rates and sends messages that it will continue to do so, we say the bank is dovish. When a central bank is in a tightening cycle, meaning that it raises interest rates in multiple steps, and sends messages that it will continue to do so, the central bank in question is in a hawkish mode.
Forex traders pay very close attention to a central bank’s interest rate actions and the forward guidance they issue on the future, possible level of interest rates. Traders assess the language used by the bank and its governor to look for clues whether the central bank is likely to increase or decrease interest rates. When traders believe the central bank is about to raise interest rates, they will likely open positions to buy that nation’s currency. When traders anticipate falling interest rates, they will likely sell that currency.
Central bank forex market intervention
During times of financial stress and extreme volatility, central banks can intervene in the forex market by buying and selling large amounts of the nation's currency. This is called market intervention and it usually occurs when the currency is undergoing excessive downward or upward pressure.
If a central bank wants to weaken the national currency (i.e. to make exports more competitive), it will buy foreign currency and sell the local currency in the forex market. If the local currency weakens to a level that makes imports very expensive, the central bank may intervene to strengthen the local currency by buying large quantities of it.
With market intervention, central banks alter the exchange rate of their currency to benefit the local economy.
A central bank intervention typically involves very large amounts of money (often billions of dollars) and can move the exchange rate of a currency by several percentage points at times. As a result, this type of action from a central bank will have a meaningful impact on the value of a given currency and forex traders need to pay close attention to any such action. During central bank interventions, currency traders are advised to use stop loss and not to trade against the direction of the intervention.
Managing foreign currency reserves
Central banks are also responsible for managing the nation’s foreign currency reserves. These reserves, often called foreign exchange reserves, are held in reserve by the central bank to back financial liabilities, ensure sufficient liquidity and help manage the exchange rate. Depending on the economic situation and the level of the reserves, central banks may decide to buy foreign currency or sell the local currency in the open market. By doing so, they are able to prevent their currency from becoming undervalued or overvalued.
In the course of any action taken by central banks to manage the country’s foreign currency reserves, the exchange rate of the currency will be impacted and therefore this is an important aspect to be considered by any forex trader.
If you are a beginner thinking about diving into forex trading, we recommend you build your trading strategy with an eye on the impact of central bank actions. Some of these are scheduled events and if you use an economic calendar, you will know when central banks are scheduled to hold interest rate meetings or when central bankers deliver speeches. Most forex brokers have an economic calendar on their website or trading platform.
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Major central banks in the world
Not all central banks are created equal. Those that operate in the world’s largest economies (i.e. the US, the European Union or Japan), have an influence that goes beyond the borders of their countries.
We will briefly introduce some of the most important central banks in the world.
European Central Bank (ECB)
The ECB acts as the national bank of all the countries that adopted the euro. As such it sets the interest rate for the eurozone and it leads the European System of Central Banks (ESCB), which consists of the central banks of the eurozone, as well as other EU member countries that have not yet adopted the single currency.
Federal Reserve (Fed)
The Fed is the central bank of the US and the most influential central bank on the globe. It sets interest rates through the Federal Open Market Committee (FOMC), a top body within the Fed. As a rule, the FOMC holds 8 rate-setting meetings a year when the body discusses monetary policy actions, the state of the economy and reviews financial conditions.
Bank of England (BoE)
As the central bank of the United Kingdom, the BoE is responsible for the nation’s monetary policy and ensuring the stability of the pound sterling (GBP) as well as the British financial system.
Bank of Japan (BoJ)
The BoJ, like other central banks around the world, seeks to attain price stability in the island nation through setting sets interest rates, among other measures. The bank pioneered certain monetary policy actions such as zero interset rates and quantitative easing. These have since become standard practice in other countries as well.
Swiss National Bank (SNB)
The size of Switzerland and the importance of the SNB’s decision are inversely proportional. Given the international importance of the Swiss franc (CHF), the SNB’s monetary policy decisions are closely followed on international markets.
All these central banks have a significant clout in the forex market due to the weight of their country and their currency in the world economy. Investors and traders the world over monitor the announcements, actions and interventions of these central banks, as their decisions affect the most traded currency pairs and the global economy.
FAQ
What role do central banks play in the forex market?
Central banks are crucial players in the forex market as they can influence the value of their nation's currency as well as supply and demand for that currency through monetary policy measures and other instruments. Forex traders pay very close attention to central bank actions and announcements as these can have a material impact on the exchange rate of a given currency.
Do central banks control the forex market?
The forex market is decentralized, meaning that there is no authority or entity that controls it. Nevertheless, central banks can have a very significant impact on forex markets as their actions can change the value of their nation's currency. The policy actions and announcements of some central banks, like the Fed in the US or the ECB in the EU, carry an influence that transcends national borders and has international significance due to the weight of these economies and the importance of the dollar and the euro in forex trading.
Do governments trade forex?
Governments are one of the key trading entities on the forex market. Other big players are commercial banks, various financial instititutions and institutional investors, businesses and brokerages. Individuals, called retail players, also trade on the forex market.
Further reading
- The top 3 forex trading strategies according to BrokerChooser experts
- How to trade forex - a live trade example
- Trend following strategy in forex trading
- Scalping in forex: explained by professionals
- Carry trade explained: learn the fundamentals of carry trade in no time
- How to read and use economic calendars in forex
- How to trade forex using price action
- Top 5 most traded currency pairs in forex
- Exchange rate mechanism: a detailed guide
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