Role of Central Banks and Their Influence on Currency Markets
To conclude our trilogy on fundamental analysis and external factors affecting the Forex market, I would like to talk today about the role of central banks.
👉 The first two articles you can find here:
The influence of Central banks on Forex
Forex is the largest currency market in terms of the number of players and capitalization; its daily turnover is between 5 and 8 trillion USD. The key market players are Central banks, the largest commercial banks, pensioned funds, insurance companies, investment funds. Every participant has this or that influence on the market but Central banks, in particular, have their ways and methods of moving the rates of currencies.
The largest Central banks are the Federal Reserve System in the USA, the European Central bank in the EU, the Central bank of England in Great Britain, the Central bank of Japan, the Swiss National bank in Switzerland.
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Central banks have two main instruments of influencing exchange rates: currency interventions and the interest rate.
A currency intervention means that a CB buys/sells its own national currency to maintain its rate at a certain level. This measure is resorted to when exchange rates of currencies need balancing. This is quite a rare occasion. More often, Central banks use oral interventions, when somebody from the administration, usually the head of the CB, announces probable buys in the open market. Also, forecasts of the economic and monetary policy are such verbal interventions.
It is the task of Central banks to form and carry out the credit and monetary policies of their countries and to regulate the interest rate. The money and credit policy of Central banks pursue various goals, including the regulation of the rate of the national currency and control over the inflation rate.
Under the interest rate, we mean the “price of money”, or the fee that a bank/client pays for using the resource. In other words, this parameter defines the price of credits and the interest on deposits in the country. Clearly, the interest on credits will be higher than on deposits, the difference being the source of income for banks. Central banks influence the rate in the following way: when they decrease the discount rate, credits become cheaper, which brings the price of the currency down; when they increase the discount rate, credits become more expensive, and so becomes the national currency.
To trade successfully in Forex, you need to keep a close eye on all actions of Central banks and the speeches of their heads. The unique and exclusive right of a Central bank is issuing coins and banknotes, i.e. money both cash and non-cash. Using their right for printing money, CBs can generate unlimited credits that will be distributed between market participants. There is a crucial detail, however: if money is not supported by gold, and a CB issues it in an unlimited way, this may play a practical joke on the economy of the government that uses these opportunities for reaching political goals.
Also, Central banks are usually responsible for regulating the banking sector as “creditors of the last resort”.
However, CBs are not “almighty”. Their nearly unlimited powers may easily destroy the economy and provoke financial chaos if used unwisely. One of the most important limitations faced by Central banks when forming the credit and monetary policy is the fact that it is impossible to manage the currency rate, interest rates, and keep the economy open simultaneously.
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The main Central banks
The US Federal Reserve System
The part of a Central bank in the USA is played by the Federal Reserve System. It unites 12 regional banks. The most important and influential one is the Federal Reserve Bank of New York because it is responsible for international financial activities. Moreover, the Fed includes 24 departments and 5.6 thousand commercial banks. One more crucial part of the Fed is the Federal Open Market Committee that regulates the buying/selling of securities.
The Fed is the regulator of the national economy. The peculiarity of its policy is its struggle against inflation and deflation. Moreover, the Fed is to keep the national rate stable. Also, it is responsible for the size of credits meant for buying/selling securities. Finally, it controls all the US banks that operate overseas.
The Fed is absolutely independent in deciding upon the economic policy. Markets are ready to react rather actively to the speeches of the head of the Fed, especially if they speak about the interest rate.
The European Central bank
The European Central bank (ECB) does not differ from any of its “counterparts” except for the fact that it serves as the Central bank for all the member countries of the EU. The ECB is a joint-stock company, the stocks of which are distributed between the national banks of the member countries. The ECB consists of the following bodies:
- the Governing Board is the supreme management body (that decides upon the refinancing rate);
- the Executive Board executes the decisions of the ECB;
- the General Council is a consultant for all the bodies.
The ECB has the following functions:
- emission of the euro;
- managing discount rates in the EU (the main rate, deposit, and credit rates);
- bank supervision (advisory);
- consulting in the eurozone.
The priority of the ECB policy is price stability. The euro rate “contains” the economies of all the member countries of the EU, that is why the policy of the ECB has a direct influence upon the political and economic changes in Europe on the whole and each of the European countries. ECB representatives usually drive the market; moreover, their statements may differ a lot from the local market psychology.
The Bank of England
The Bank of England acts as the CB of Great Britain and pursues two goals: monetary and financial stability. In Great Britain, they use the Twin Peaks pattern for regulating the financial industry: one of the “Peaks” is the Financial Conduct Authority and the second one is the Prudential Regulation Authority. The Bank of England prudentially regulates financial services, requiring companies sufficient capital and adequate risk management.
The Bank of Japan
The BoJ is not an administrative body but a joint-stock company: 55% of its capital belongs to the government and 45% — to individual and institutional investors. The priority of the BoJ is price stability and the stability of payment and settlement systems.
The BoJ carries out the following functions:
- issues banknotes;
- carries out the monetary and credit policy (changes the norms for rest funds, controls operations in financial markets, regulates the discount rate);
- regulates the settlements of commercial banks;
- monitors and checks the financial and management state of financial institutions;
- operates state securities;
- carries out international activities;
- carries out economic analyses and theoretic research.
On January 29th, 2016, the interest rate of the BoJ was brought down to the negative value of -0.1%. In autumn-2016, the board of directors of the BoJ decided to leave the rate at -0.1%. It lasted long in the attempts of the Bank to revive the economy.
Every quarter, the BoJ issues the Tankan Survey that reports business confidence and expectations. The Survey has been published since 1957. The data is collected from 9,000 institutions belonging to one of the four main groups: large, medium, small, and leading organizations. The report consists of the following data:
- business conditions;
- the demand and supply conditions for production and investment;
- profits of corporations;
- fixed investments and production powers;
- employment conditions;
- tax conditions.
Based on this data, the BoJ calculates the so-called diffuse indices:
- are business conditions good or bad?
- are the stock levels, demand, employment, and business conditions satisfactory?
- have the financial conditions become better or worse for companies?
- are crediting conditions good or bad?
The indices are calculated by subtracting the number of polled with a negative opinion from the number of those with a positive opinion. The Tankan Survey gives a good picture of the business climate in Japan and, thus, has a strong influence on the yen rate.
By Dmitriy Gurkovskiy, Chief Analyst at RoboForex