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| =='''Central Bank [[Monetary Policy Tools]]'''== | | =='''Central Bank [[Monetary Policy Tools]]'''== |
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| ===Ways to Manipulate the Money Supply===
| | Central banks are major monetary authorities that attempt to control the size and growth of money in several ways using [[Monetary Policy Tools]]. In the following Wiki on [[Monetary Policy Tools]] we will cover the types and kinds of tools that Central Banks use to control and steer the economy in their desired direction. We will look at: |
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| Central banks are major monetary authorities that attempt to control the size and growth of money in several ways: | | * [https://volatility.red/Monetary_Policy_Tools#Interest_Rates Interest Rates] |
| | * [https://volatility.red/Monetary_Policy_Tools#Price_Controls Price Controls] |
| | * [https://volatility.red/Monetary_Policy_Tools#Reserve_Requirements Reserve Requirements] |
| | * [https://volatility.red/Monetary_Policy_Tools#Credit_Control Credit Control] |
| | * [https://volatility.red/Monetary_Policy_Tools#Central_Banker_Language Central Banker Language] |
| | * [https://volatility.red/Monetary_Policy_Tools#Moral_Suasion Moral Suasion] |
| | * [https://volatility.red/Monetary_Policy_Tools#Open_Market_Operations Open Market Operations] |
| | * [https://volatility.red/Monetary_Policy_Tools#Quantitative_Easing Quantitative Easing] |
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| * Interest Rates
| | The main Wiki on [[Monetary Policy Tools]] can be found [https://volatility.red/Monetary_Policy_Tools HERE]. |
| * Price Controls
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| * Reserve Requirements
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| * Credit Control
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| * Central Banker Language
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| * Moral Suasion
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| * Open Market Operations
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| * Quantitative Easing
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| ===Interest Rates===
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| ====Understanding Interest Rates====
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| Interest rates have “traditionally” been considered to be one of the primary tools a central bank will use in order to effectively manage the health of an economy.
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| If we break interest rates down into their most basic use we can say that they are generally used to attempt to control [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] within the economy. They are known as a “Traditional Monetary Policy Tool”. Interest rate changes are typically done by changing the “discount rate”.
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| ====Interest Rate Examples====
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| As an example, if [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] is increasing faster than the central banks would like then the central bank will look to increase interest rates in order to try and slow the economy down. Because increasing interest rates increases the costs of doing business it ultimately discourages people from borrowing and spending.
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| Raising interest rates will also encourage people and companies to start saving their money. This has traditionally been used as an effective tool to reduce the rate at which [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] goes up.
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| On the other hand, if [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] is low or falling, the central bank will look to cut its interest rate. The idea is that this will discourage people from holding onto their money and start spending it. This actually encourages people and companies to start borrowing and spending more money within the economy. Investment and spending will generally pick up because companies and people can borrow money at lower interest rates than they could previously. This lowers the barrier for entry to more people and companies who may not have been able to borrow at the previous higher interest rates.
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| ====How the [[Forex]] Market Focuses on Interest Rates====
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| Any hint that forces [[Forex]] traders to think that a central bank will adjust its interest rate either up or down can provide them with some excellent [https://volatility.red/Trading trading] opportunities.
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| For example, if a certain central bank is indicating to the markets that it's thinking of cutting its interest rate then the market will go to work and attempt to [https://volatility.red/Price_Action_Analysis price] this new information into the [[currency]]. This is what creates some great [https://volatility.red/Trading trading] opportunities to short that specific [[currency]]. We would want to look for short trades because we know that cutting interest rates is bad for [[currency]] valuations.
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| If a country cuts interest rates then large asset management companies will move their money out and into another country with higher yields. Money comes out of the [[currency]] which means selling, and selling means the [https://volatility.red/Price_Action_Analysis price] goes down.
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| '''What [[Forex]] traders do is look to trade in line with the central bank’s current and expected interest rate policies.''' This is one of the best ways traders can make money in [[Forex]] [https://volatility.red/Trading trading]. Trade the 'current' situation for a bit of profit and trade the 'expectations' of the future for much bigger profits.
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| Interest rates are one of the biggest things that the [[Forex]] market will obsess over. If you think about it, a country's interest rate is the interest rate that you will be paid for holding that specific [[currency]]. As an example, if you are holding Great British Pounds long and the interest rate of the UK is currently 5% then this means that you will receive 5% per year just for holding Great British Pounds.
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| That sounds like a pretty simple way to make 5% per year and this is exactly how a lot of large asset management companies think. This is called a ''carry trade''. The largest financial companies in the world are not trying to make 100% per year. If they can get 5-10% the bankers are all going to get massive bonuses.
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| The other big benefit of moving money into a high-interest rate paying [[currency]] is the potential for the [[currency]] to gain in value. This tends to happen as more and more investors want to own Great British Pounds to gain the high-interest rate in our example. Their buying of the [[currency]] naturally moves it higher over time.
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| One thing to keep in mind is that it’s not difficult to figure out what the market is thinking. How the markets are thinking will be plastered all over the news feeds on a daily basis. It really only takes a few minutes of scanning the news wires to figure out what the market is obsessing about today.
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| It’s also very easy to understand what the central banks are thinking because they will literally tell us in their press conferences and in other communications to the market. These are deliberately designed to keep the market in step with their policies so that they can control [https://volatility.red/Price_Action_Analysis price] stability within their country’s [[currency]].
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| Almost all central bank meetings and press conferences are scheduled weeks in advance. Any decent [https://volatility.red/Economic_calendar economic calendar] should have these clearly highlighted so that you are prepared for potential market-moving events.
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| Interest rates are a medium to longer-term tool because it typically takes time for the effect to filter through the economy. This is why central banks have many tools that they can use.
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| ===Price Controls===
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| A [https://volatility.red/Price_Action_Analysis price] control is simply that. It is a way to control the [https://volatility.red/Price_Action_Analysis price] of a country’s [[currency]]. This can be done directly or indirectly by a central bank.
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| [https://volatility.red/Price_Action_Analysis Price] controls happen when a central bank tells the market that it desires the [https://volatility.red/Price_Action_Analysis price] of its [[currency]] to be at a specific [https://volatility.red/Price_Action_Analysis price level]. If they are doing it “indirectly”, the central bank will simply communicate or threaten to act if the [https://volatility.red/Price_Action_Analysis price moves] too far away from where they want the [https://volatility.red/Price_Action_Analysis price] of their [[currency]] to be.
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| If the central bank decides to act “directly”, they will provide a very specific [https://volatility.red/Price_Action_Analysis price level] and make it clear that every time the [https://volatility.red/Price_Action_Analysis price] looks like it will breach their [https://volatility.red/Price_Action_Analysis price] limit they will step in and intervene to keep the [https://volatility.red/Price_Action_Analysis price] in line with its target. They would typically intervene by buying up or selling huge amounts of their own native [[currency]] in the open market.
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| '''Swiss National Bank Price Control Example'''
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| An example of [https://volatility.red/Price_Action_Analysis price] control was when the Swiss National Bank (SNB) created a [https://volatility.red/Price_Action_Analysis price] floor for the Euro-Swiss (EURCHF) [[currency]] pair between 2011 and 2014. They felt it was in their best interest to not have the Swiss Franc appreciating against the Euro so they imposed a floor on the pair at a [https://volatility.red/Price_Action_Analysis price] of 1.2000.
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| They did this because the Eurozone is Switzerland’s largest trading partner. If the [https://volatility.red/Price_Action_Analysis price] of the EURCHF dropped too far this would have a negative impact on their exporting companies that relied on the higher value Euro as part of their ability to remain profitable.
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| If the [https://volatility.red/Price_Action_Analysis price] came close or broke the floor at 1.2000 the SNB would step in and intervene by literally buying up the currency pair. They would sometimes buy billions worth of Euros to make sure the [https://volatility.red/Price_Action_Analysis price] would not go below the 1.2000 handle.
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| The market did not believe the SNB at first but after several failed attempts to push the EURCHF pair below 1.2000 the market finally gave up and the [https://volatility.red/Price_Action_Analysis price] held consistently above the 1.2000 level for a couple of years.
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| This kind of action creates an interesting opportunity for a trader. If you have a central bank backing a trade to buy at a certain [https://volatility.red/Price_Action_Analysis price] level then this can create an opportunity to trade in line with the central bank with very little [https://volatility.red/Risk risk]. The [https://volatility.red/Risk risk] can be very low because a central bank can print money endlessly but the rest of the market cannot. Generally, the central bank will always win the battle because they just have so much more firepower.
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| The major [https://volatility.red/Risk risk] to a trade like this is that the central bank can abandon its policy at any time without notice to the market. Guess what? In early 2015 the SNB removed the [https://volatility.red/Price_Action_Analysis price] floor very unexpectedly which sent the market into complete chaos as traders tried to find a new fair value for the EURCHF pair. You can see from the daily chart of the EURCHF that the [https://volatility.red/Price_Action_Analysis price] hung at or slightly above 1.2000 for a long time until the SNB pulled the rug out from under the market. It actually dropped about 2,300 pips or almost 40% in minutes!
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| https://i.imgur.com/EsRUWFB.jpg
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| This event wiped out a lot of traders who were relying on the SNB to hold the [https://volatility.red/Price_Action_Analysis price] floor at 1.2000. It even instantly put large well establish [https://volatility.red/Forex_broker Forex brokers] out of business because of the huge number of client accounts that went into the negative and could not be paid back.
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| One of the things that made this event so chaotic was the fact that only 3 days before the SNB pulled the [https://volatility.red/Price_Action_Analysis price] limit they actually went on record stating that they would defend the [https://volatility.red/Price_Action_Analysis price] limit with the “Utmost Conviction”. They communicated this to the market because this was at a time when the Euro was plummeting day after day on the back of the European Central Banks' decision to start a new quantitative easing program.
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| We can only guess that the SNB members did a little bit of math and decided it would cost too much money to defend the [https://volatility.red/Price_Action_Analysis price] limit given the terrible outlook of the Eurozone and the major devaluation that was taking place in the Euro.
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| Fixed [https://volatility.red/Price_Action_Analysis price] controls, such as the one the SNB used, are rare but less formal versions are more common. Often central banks will tell the market where they would like the [https://volatility.red/Price_Action_Analysis price] of the [[currency]] to be. When they do this it’s a time that traders should be paying attention.
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| ===Reserve Requirements===
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| Reserve requirements are sometimes referred to as reserve ratios of asset ratios.
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| Reserve requirements are the requirements regarding the percentage amount of cash a bank must hold in reserve against deposits made by customers at their banks. This cash must be held physically in the bank's vaults or stored at the closest Central Bank.
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| Said another way, the reserve ratio is the portion of all depositors’ cash balances that the banks must physically have on hand as cash so that clients can make normal everyday withdrawals.
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| These requirements are set by the central bank of each nation and are one of the main tools of traditional monetary policy.
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| ====How Central Banks Use Reserve Requirements====
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| When the economy is doing well and [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] is rising a central bank will look to increase the reserve requirement to keep [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] in line with their mandate. They do this to try and slow down lending which would ultimately slow down [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] because people and companies will likely borrow and spend less. However, this does serve the purpose of storing more cash at regional banks when times are good so that when the economy takes a turn for the worse there is plenty of cash on hand in the banks to cover the client needs. It also means that if a recession hits the central bank can lower the reserve requirements so that the regional banks can start lending that idle cash and hopefully stimulate the economy.
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| When [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] is falling the central bank might look to decrease the reserve requirement in an effort to pump extra money into the financial system. The hope is that the banks will use this extra money to start lending out to companies for capital projects. This in turn could decrease unemployment and put people back to work.
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| Consumer spending is a major component of GDP so if more people have jobs then there will be more people spending money which will show up in the consumer spending numbers.
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| You can find the current reserve ratios for most central banks around the world at the following link. You might be surprised just how little cash banks are actually required to hold onto.
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| [http://www.centralbanknews.info/p/reserve-ratios.html centralbanknews.info] | |
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| ===Credit Control===
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| Credit control happens when a central bank imposes limits on how [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions] can lend out money to other businesses or consumers.
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| Credit control can also be used to set limits on the amount of money that regular consumers can borrow from [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions]. The idea is that you don’t want everyday people leveraging up to levels that they might not be able to afford if the market environment changes.
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| This is different from the reserve ratio in that it looks to target things other than how much banks can loan out in total. It will typically come after a reserve requirement has been set. This is usually done by creating rules around how much debt-to-income ratio companies and consumers can comfortably afford to have.
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| Credit control is a strategy that attempts to only allow the more credit-worthy people and companies to borrow from [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions]. The idea is that if an economy has too many people or companies borrowing money then there might be a high number that can’t afford to pay back what they have borrowed. Obviously, if there is a high percentage of people not paying back their loans then this can cause a pretty awful banking crisis just like the one we saw in the Great Recession that kicked off in 2007 in the United States.
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| Lending out too much money too quickly could lead to runaway [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] and destabilize the overall economy. It could also increase the number of people and companies declaring bankruptcy which is obviously not something that a central bank wants to happen.
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| ===Central Banker Language===
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| Central bank language is simply the things the central bank “says” rather than what it “actually does”. By making statements to the public about what it would like the market to do and where it would like the [https://volatility.red/Price_Action_Analysis price] of the [[currency]] to be, the central bank hopes that the market will take this language as a sufficient threat of action and then trade in line with the central banks desired route.
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| This highlights why credibility with the overall market is so essential to a central bank. Think about it for a minute, if the market doesn’t believe that the central bank will follow through on its threats then the central bank has a much more difficult time influencing the markets.
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| If the market shrugs off what the central bank says then it makes for a much tougher job in dictating monetary policy. This is why most central bankers are extremely careful about what and how they say something in the public domain because the slightest slip-up can harm the central bank's credibility. It can also cause excessive [https://volatility.red/Price_Action_Analysis price] [https://volatility.red/Sentiment_Analysis#Volatility volatility] which controlling [https://volatility.red/Price_Action_Analysis price stability] is something that most central banks are tasked with doing.
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| Most of the time language will have the desired effect but sometimes it does not. It’s at these times that the central bank may actually have to step into the market and take some kind of action so that the rest of the market believes they will follow through in the future. There is no better way to command the attention of the market than by stepping in and following through in a big way.
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| ===Moral Suasion===
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| Moral suasion is similar to central banker language but differs in that they are not typically speaking to the market as a whole. This is where the central bank will attempt to persuade [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions] to increase or decrease the amounts that they are lending to their clients. Said another way, moral suasion is a persuasion tactic used by a central bank to influence or pressure, but not force, [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions] into doing what the central bank wants them to do.
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| This is easier than outright passing laws and is often something the central bank will try and use before they are forced to pass new laws. Passing new laws could take a long time to get done. Moral suasion can happen much quicker and is sometimes needed when times are looking particularly dark.
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| Some historical moral suasion tactics that have been used are:
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| * Closed-door meetings with bank directors
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| * Increased number and severity of inspections
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| * Appeals to community spirit
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| * General threats
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| Basically, moral suasion is when the central bank jawbones [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions] into hopefully doing what they want without the central bank itself actually needing to enact a new policy.
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| ===Open Market Operations===
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| Open Market Operations (OMO) refers to the buying and selling of “government securities” in the open market by a central bank. The central bank will do this in order to increase or decrease the amount of money in the overall banking system.
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| This is basically a quick way to control the money supply. If they want to add money into the market they will buy government securities from the marketplace. This puts money into the pockets of [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions]. If they want to decrease the money supply they will sell more government securities to the marketplace. This takes money out of the pockets of financial companies.
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| In the United States, this is facilitated by the Federal Reserve (Fed). OMO is the most flexible and most common tool that the Fed uses to implement and control monetary policy in the United States. However, the discount rate is also used which is the rate at which banks borrow reserves from one another.
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| The Fed can use various forms of OMO, but the most common OMO is the purchase and sale of government securities. Buying and selling government bonds allows the Fed to control the [https://volatility.red/Fundamental_Analysis#Supply_and_Demand supply] of reserve balances held by banks.
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| If a central bank purchases government securities in the open market this will have the effect of injecting money into the banking system. This is because when a central bank buys something the money comes off the central bank’s balance sheet and into the financial companies’ balance sheets. This is different from a normal business-to-business transaction where money simply changes hands.
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| If the central bank decides to sell government securities in the open market this will take money out of the banking system. When a business buys something from the central bank it takes money off its balance sheet and transfers it to the central bank’s balance sheet. This means that this money from the business is no longer available in the money supply until the central bank decides to put it back into the economy.
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| Open market operations are a tool that central banks will use as a fast-acting tool. This is because they can literally control how much money is in the banking system as long as other participants are willing to buy and sell from the central bank at that time.
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| ===Quantitative Easing===
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| Quantitative easing has rarely been used with any significance throughout most of central banking history. However, there is the exception of the global financial crisis that started in 2007 and the subsequent global fallout. Several central banks are still using QE to support their economies at the time of this writing.
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| Quantitative easing is viewed as an unconventional monetary policy tool that many central banks use only as a last resort if the more traditional tools such as interest rates are not having the desired effect on the economy.
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| QE is the process of printing money and injecting that money into the financial system. This is usually done in the form of buying government securities and other government-linked financial assets. The central bank purchases these back from the companies that hold them so that those companies will have more money on their books. The idea is that these companies will use that extra money to pump into loans for capital projects within the economy.
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| This is done to hopefully lower interest rates that [https://volatility.red/Fundamental_Analysis#Institutional_vs._Retail_Traders financial institutions] charge and increase the money supply by flooding the financial system with fresh capital. This is an effort to promote increased lending and make sure there is enough of the vital liquidity that the market needs to function properly.
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| When the central bank does QE it serves to add more liquidity to the financial system so that it remains stable during hard [https://volatility.red/Economic_data_releases economic] times. A central bank would only consider performing QE when interest rates are at or approaching 0% and the economy is not looking like it will meet the central bank's [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] targets. If the central bank is considering QE then they are probably more concerned with [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation deflation] rather than [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation].
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| If a QE strategy is not having the desired effects then the central bank will look to target commercial banks and private sector assets rather than only buying government securities and bonds. This is when you know the economy is really unstable and has a lot of issues to sort out. Effectively, if the central bank starts buying public sector debts and assets then you know that they are extremely concerned about a potential depression rather than just a recession. Think about that; a central bank doesn’t want to own unstable public assets with an uncertain future when it could own its own debt but hard times call for major measures to be taken.
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| Quantitative easing serves the purpose of stimulating growth and investment because there is so much fresh and cheap money going around. It can also devaluate the [[currency]] because more [https://volatility.red/Fundamental_Analysis#Supply_and_Demand supply] is being printed faster than the natural rate of demand is able to absorb it. This [[currency]] devaluation further encourages growth as the country’s exporters become much more competitive which is good for the economy overall.
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| Generally speaking, QE has proved itself to be extremely effective so when the central bank threatens to or actually implements QE the market will pay very close attention.
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| ===Final Thoughts on Central Bank Tools===
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| When a central bank implements any of these tools it gives [[Forex]] traders the opportunity to potentially find a profitable trade. All you need to do is be tuned into what is going on with the [https://volatility.red/Economic_data_releases economic] indicators that the central banks are watching and then listen to what the central bank is telling the markets about those indicators.
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| The question traders should be asking is; Is the central bank happy or concerned with a particular indicator? They will tell us! This will prepare you extremely well to seize excellent [https://volatility.red/Trading trading] opportunities as they come up.
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| You might be thinking that this all sounds very simple; you get the concepts and understand that it’s the central bank's actions that cause most of the [https://volatility.red/Price_Action_Analysis price moves] in the [[Forex]] market. But you might be wondering how you will figure out exactly what the central bank is thinking of doing. Surely this is important information to be aware of if the central banks play such a big role in the [[Forex]] market. This is a fairly simple process because the central bank will rarely focus on more than one or two specific things at any one time. This makes it much easier to track and understand what is going on right now.
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| For example, if the central bank is worried about [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] being too low they will express this concern to the market. As traders, we know that there is a good chance they will cut interest rates in order to fight the falling [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] rate. This is the information traders can trade in line with. Cutting interest rates or the 'expectation' of falling interest rates will have a negative impact on the particular [[currency]].
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| In this scenario, traders can forget all about production or housing data because we know that the central bank is now looking at low [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation] as a primary concern. Traders will need to focus on inflation-related data and anticipate the central bank using tools associated with [https://volatility.red/Fundamental_Analysis#Inflation_and_Deflation inflation]. In this case, the tool would be interest rate cuts. Traders can then determine how that action will impact the [[currency]] and trade in line with it.
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| The central bank will express this information in what is called “[[forward guidance]]”. [[Forward guidance]] is the act of the central bank telling the market its intentions so as to not cause irrational [https://volatility.red/Price_Action_Analysis price] instability when they do make a policy adjustment.
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| Most central banks will leave little breadcrumbs for the market to pick up on. They typically won’t outright tell the markets their exact plans because that would cause too much immediate [https://volatility.red/Price_Action_Analysis price] [https://volatility.red/Sentiment_Analysis#Volatility volatility]. Instead, what they do is leave a trail of hints and clues in the weeks and months going into a policy change. This way the impact on the market is minimized and happens gradually rather than abruptly causing [https://volatility.red/Price_Action_Analysis price] shocks.
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| If traders focus on what the central bank is focusing on then their [https://volatility.red/Trading trading] becomes much simpler. Focus on the indicators, focus on the central bank, and once traders know what the central bank is focusing on we can then they can figure out what tools they could possibly use and how it will impact the markets.
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A central bank is an institution that is responsible for setting the monetary and interest rate policies for the country in which they reside. This means that it’s the job of the central bank to make sure that the economy is stable and growing while the prosperity of its nation's citizens continues to strengthen. This is no small task either because most major nations are rather large and have a lot of moving parts within their economy.
Introduction to Central Banks
All developed nations have their own central bank that is tasked with controlling the country’s monetary policies. The monetary policy actions of the central bank will directly influence the price movements of the country’s currency. This is because they have full control over the available money supply and set the interest rates. This makes them a big deal to the Forex market.
Control over interest rates, money supply, monetary policy, and much more is why central banks are so important to watch for all Forex traders. Everything that they do will have a certain degree of impact on the price of their currency, and therefore, will have an impact on the trading decisions that Forex traders will take.
There will be many times when the central banks will dictate how a trader will navigate Forex the market. In fact, when central banks need to make decisive policy actions these are the times when it’s actually less risky and there are more pips to be made. Even though it can be more volatile in these times it can make for very safe trades if a trader has an excellent understanding of the fundamental situation with central banks and the Forex market.
One of the things that a Forex trader needs to do is monitor what the central banks are doing and saying. The process for monitoring central banks is quite simple. But before a trader gets too bogged down worrying about all the policies and intricacies of the central banks, all they really need to understand is what the central banks are thinking or what is currently concerning them the most right now in real-time. Traders typically do not need to concern themselves with things that the central banks themselves are not concerned with. This makes the interpretation of a central bank a bit simpler.
It’s important when a trader is analyzing a central bank to appreciate that there are only one or two things that they need to concern themselves with at any given time. The things that Forex traders need to be concerned with are the exact same things that the central banks are saying they are concerned with. Whatever they are concerned with is going to drive their decisions on how they are looking to enact their monetary policies to keep the economy stable and growing. As a consequence of this analysis, traders get insight into where interest rates may be headed in the near future.
Why Traders need to know what Central Banks are Thinking
The reason traders need to know what a Central Bank is thinking is that if traders know how the central banks are thinking, what they are happy and unhappy with, then they can use that information to try and predict how the market will react to that information in the very near future. This is because big institutional players are searching for these same clues because they too are trying to get in on developing price trends as early as possible. It’s human nature to want to predict where the price of something is heading so that we can make the most money with the least risk in the shortest amount of time possible. This is the thought process of the big players and is the same process that retail traders want to be in tune with.
Since the actions that the central banks take will move the price of currencies, this can offer us some excellent trading opportunities to trade around.
Questions to Ask about Central Banks
- What are the central banks thinking?
- What is their next possible move on interest rates and why?
- How is their nation’s economy performing?
- What is the central bank concerned with?
- What economic data has the central bank stated they are watching closely? (These will be the economic data sets that traders want to monitor closely as well).
A Brief History of Central Banks
Let’s take a quick look at central bank history for some context on how the modern financial system got to where it is today.
1870 - 1914
Between 1870 and 1914 the value of most major currencies was pegged to gold. This meant that it was much easier to maintain a stable currency price than it is today when there is no [gold standard] in place. This is because the amount of gold available in the world was limited so it wasn’t too difficult to keep inflation under control. The price of gold was also historically quite stable at the time.
During this time the main role of the central bank was to ensure that people were able to convert gold into currency and issue an appropriate number of bank notes based on the country’s reserve of gold.
World War 1 and 2
Then came along World War 1 and 2 which forced central banks all over the world to change course. The financial toll associated with the cost of war became so large that governments needed to raise a lot of extra money and they needed to do it fast to keep up with all the cost pressures. War is certainly not a cheap thing to do.
They raised this extra money by abandoning the [gold standard]. With this newfound power to do whatever they wanted governments started printing vast sums of money to pay for the extra costs of war and repairing all the damages that resulted from the fighting. Doing this led to steep inflation, which in many parts of the world became completely out of control. Inflation went so high that it forced most governments to eventually return to the gold standard.
Because it was obvious that politicians with too much power over the supply of money is not good for the stability of their country’s currency the solution was to create completely independent central banks to guide monetary policy outside of politics.
Central banks have been around for hundreds of years but in their current status and design, they have only been around since about the mid-20th century.
Central Banks and Interest Rates
Before delving further into central banks it makes sense to understand a little about interest rates first. Traditionally, Forex market traders have been heavily invested in understanding interest rates and interest rate policies. It is consumed over what interest rates are for a particular nation and, more importantly, where they think interest rates are heading over the medium and long term outlook. The expectations are one of the most important things the Forex market will attempt to price in and nowhere is this truer than when it comes to interest rates.
The Forex market participants will aggressively try and price in their expectations of future interest rate policy virtually every day. This is because there are so many asset management firms that are heavily dependent on the interest paid for holding particular currencies in their portfolios. These large asset management firms rely heavily on guaranteed interest payments from central banks and government bonds. Many of the largest asset management firms in the world are heavily invested in multiple countries and therefore need to watch the particular currencies of the countries they are invested in quite closely.
If interest rates are rising in a particular nation then this is generally considered to be a positive thing for the native currency which tends to move higher in interest rate hiking cycles. If interest rates are falling within a particular nation then this is typically a bad thing for the native currency and prices typically fall.
It’s the central bank of each nation that controls the interest rate for their respective nation. If the Forex market is obsessed with interest rates and the path they are headed on, then it makes logical sense that Forex traders would want to get to know the central bank of the nation’s currency that they are interested in trading.
Because the central banks control interest rates this forces the Forex market participants to become laser focussed on what each individual central bank is talking about and doing in the market. The market also pays very close attention to the individual central bank members as well.
Overview of what Central Banks do
A central bank's main job is to control monetary policy for the country in which they serve. Basically, they do this by manipulating the money supply.
Money Supply: This is simply the total amount of money that is available within the financial system of a particular nation. It’s the amount of money currently in circulation within an economy.
Central banks are generally considered to be the “lender of last resort”. This means that when the economy is struggling and commercial banks cannot cover the demand for money the central bank has the power and the resources to step in and take an appropriate level of action. In other words, the central bank is there to stop the banking system from collapsing in on itself. They do this by manipulating the available money supply.
Most modern economies are very complex, and because of the lack of regulations, financial systems tend to get themselves into trouble about once every 10 years on average. This is why central banks need to keep a close eye on developing trends in the economy to make sure that things don't get out of control, cause a financial system shock, or become unmanageable.
Aside from the primary objective of controlling the money supply, most central banks are also tasked with providing the country’s currency with price stability. It also has regulatory authority over the country’s monetary policy along with the sole right to produce and circulate new currency inside the country.
Central banks are separate from the governments of each nation. The idea is that they should perform mostly autonomously from any political issues that may be going on inside the world of politics. This is because politicians don’t have the greatest track record when it comes to managing money. This is exactly why we have central banks.
Having said that, the central bank is often referred to as “the government’s bank” in the sense that it’s the one that handles the buying and selling of government bonds and other similar transactions.
Monetary Policy and Money Supply
Before we deep into the tools that central banks use to enact monetary policy it would be useful if we first took a more in-depth look into what monetary policy actually is.
Monetary policy consists of the actions that a central bank takes which determine the size and rate of growth of the available money supply. This in turn will have an effect on interest rates because interest rates are one of the central bankers favorite monetary policy tools they use to help steer the economy.
Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep on hand for client withdrawals.
Broadly speaking there are two types of monetary policy; expansionary and contractionary. This is what we will take a look at next.
Expansionary Monetary Policy
Expansionary monetary policy attempts to “Increase” the money supply in order to lower unemployment, boost private-sector borrowing, encourage consumer spending, and stimulate overall economic growth.
This is often referred to as "easy monetary policy." This easy monetary policy description applied to almost all major central banks after the 2007-2008 Great Financial Crisis. Almost all developed nations slashed their interest rates in an attempt to get their economies growing and expanding again.
Many economists have described this time as a modern-day depression. Interest rates were driven way down and in many cases near zero across most G8 central banks. In fact, some central banks set their interest rates below zero which means they had negative interest rates! This is not something that the world has ever seen before and we are not totally sure what the long-term ramifications are for such untraditional actions just yet.
Can you imagine putting your money into a bank and having them tell you that they are going to charge you interest for the privilege of holding onto your cash? But this is exactly what happened and is currently still happening.
Contractionary Monetary Policy
Contractionary monetary policy attempts “Decrease” or slow the rate of growth in the money supply. Sometimes a central bank will need to outright decrease the money supply in order to control inflation that is growing at a rate higher than the central bank's mandate.
Historically speaking, this has sometimes been a necessary option for a central bank. There are times when contractionary monetary policy is needed to slow economic growth, increase unemployment and depress borrowing and spending by consumers and businesses. It is just not sustainable to think an economy can grow infinitely at large growth rates. This is only done in a situation where inflation is getting way too high and needs to be controlled.
The point here is that central banks are trying to keep inflation stable and in line with their mandate. This is typically around 2% per year. If inflation starts to get too low then they will have an expansionary monetary policy and will use the tools they have to stimulate inflation. If inflation starts to get too high then the central bank will switch to a contractionary monetary policy. The whole point is to control boom and bust cycles by keeping volatility within the economy low.
When Contractionary Monetary Policy Goes Wrong
Monetary policy is not perfect all the time. It really is quite a difficult balancing act to steer economies that are so large and have so many moving parts. Let’s look at a quick example of when contractionary monetary policy goes so wrong for a couple of obvious reasons.
In the early 1980s, the Federal Reserve was forced into a situation where they had no choice but to stage an intervention. The Fed really dropped the ball and allowed inflation to get completely out of control which now reached roughly 15% annually. Do you think this was a little out of line with their mandate of keeping inflation levels stable at around 2%? It’s not like inflation went up to 15% overnight, it was years in the making.
This out-of-control inflation forced the Fed to take decisive action. In a historical event, they chose to raise the benchmark interest rate to 20%! This hike resulted in a severe recession. However, it did keep the out-of-control inflation in check by unfortunately causing harm to many everyday people and companies. There was simply no way for regular people to prepare for that level of interest rate shock.
It's obvious that inflation got so out of control because the Fed waited way too long to start slowing down the economy. Had the Fed reacted years earlier it could have kept with one of its mandates to keep price stability under control. This is considered one of the few times that a major central bank failed miserably to meet its mandates to the economy.
Exchange Rates
Exchange rates, or the pricing of currency, are generally moved by forces outside of the control of central banks. But this is not always the case because sometimes central banks will step into the market and attempt to influence the pricing of exchange rates.
We have a larger Wiki on Exchange rates that covers everything you need to know including What an Exchange Rate is, Exchange Rate Examples, The Technical Aspects of Exchange Rates, How Exchange Rates are priced and Exchange Rate Pricing Theories.
The main page for Exchange rates is found here: Exchange rates
Money Supply
The money supply is just that; it’s the available supply of money that is circulating within an economy and globally of one particular currency. The central bank of each nation is tasked with controlling their country’s supply of money. The money supply is sometimes referred to as the “Money Stock”.
The central bank of each nation manipulates the money supply. They will increase or decrease the money supply depending on what their current monetary policies are. They do this by using a series of tools that can be employed in different market environments. A lot of this depends on where they believe they are in the economic cycle.
There are several tools that central banks can use to enact their monetary policies. In the next section, we will take an in-depth look at what tools the central banks have and how they use these tools to move the economy in the direction they desire.
Central banks are major monetary authorities that attempt to control the size and growth of money in several ways using Monetary Policy Tools. In the following Wiki on Monetary Policy Tools we will cover the types and kinds of tools that Central Banks use to control and steer the economy in their desired direction. We will look at:
The main Wiki on Monetary Policy Tools can be found HERE.
Now we are going to look at the individual central bank members' stances. That’s right, not all central bankers within a particular central bank will want the same thing when it comes to monetary policies. This means that some may prefer to have higher interest rates and other members will prefer lower interest rates and they are called Hawks and Doves. The differences in those opinions are what we discuss in the following Wiki on Hawks and Doves.
In this Wiki on Hawks and Doves you will learn the differences between a Hawk, a Dove and a Centrist. We will also explore Central Bank Member Speeches, Why not all Central Bankers are Created Equal, and why we as traders Care about Hawks and Doves.
You can access the Wiki on Hawks and Doves HERE.
Major Central Banks
The Federal Reserve is by far the most influential central bank in the world at the time of this writing in mid-2022. Its currency is involved in an estimated 70% of all FX transactions that take place every single day. Because of this, the actions that the Fed takes can have a strong impact on most of the world’s currency valuations. This is because the USD is one-half of most all major currency pairs.
For these reasons and more, we have created a separate Wiki devoted to understanding the Federal Reserve. In this Wiki, you will learn about the Fed Structure, its Mandate, Fed Minutes, Forward Guidance, and How the Fed Enacts its Monetary Policies.
The main Wiki for the Federal Reserve can be found HERE.
The European Central Bank (ECB) is the prime component of the Eurosystem and the European System of Central Banks (ESCB). It is also one of seven institutions of the European Union. At the time of this writing the ECB is one of the most important central banks in the world.
In this Wiki we will explore the ECB structure, Forward guidance, the ECB meetings, their mandate and more.
The main Wiki for the European Central Bank can be found HERE.
The Bank of England (BOE) is the central bank of the United Kingdom and the model on which most modern central banks have been based. The BOE was established in 1694 to act as the English Government's banker, and is still one of the bankers for the Government of the United Kingdom.
In this Wiki we will take a look at the Bank of England's Structure, Mandate and more.
The main Wiki for the The Bank of England can be found HERE.
The Bank of Japan (BOJ) is headquartered in the Nihonbashi business district in Tokyo. The BOJ is the Japanese central bank, which is responsible for issuing and handling currency and treasury securities, implementing monetary policy, maintaining the stability of the Japanese financial system, and providing settling and clearing services.
In this Wiki we will look at the BOJ structure, BOJ jawboning, their mandate and more.
The main Wiki for the The Bank of Japan can be found HERE.
The term Swiss National Bank (SNB) refers to the central bank of Switzerland. Founded in 1906, the SNB is located in Berne and Zurich, with six other offices in the country along with a branch office in Singapore. The central bank acts as an independent body, taking charge of the country's monetary policy and ensuring national price stability.
In this Wiki we will cover the SNB structure, Monetary Policy, Export Policies and more.
The main Wiki for the Swiss National Bank can be found HERE.
The Bank of Canada (BOC) is Canada's central bank and was established in 1934 under the Bank of Canada Act. The Act stated that the Bank of Canada was created “to promote the economic and financial welfare of Canada.” The BOC and its Governor are responsible for setting monetary policies, printing money, and determining the Canadian banks' interest rates.
In this Wiki, we will explore the Bank of Canada, its structure, monetary policy and more.
The main Wiki for the The Bank of Canada can be found HERE.
The Reserve Bank of Australia (RBA) is the central bank of Australia. The bank sets the country's monetary policy and issues and manages the Australian dollar. The RBA is involved in banking and registry services for federal agencies and some international central banks. The bank is owned entirely by the Australian government and was established in 1960.
In this Wiki, we will explore the RBA, its structure, mandates and more.
The main Wiki for the The Reserve Bank of Australia can be found HERE.
The Reserve Bank of New Zealand (RBNZ) is the name of the central bank of New Zealand. Its primary purpose is to maintain the stability of New Zealand's financial system.
In this Wiki, We will explore The Reserve Bank of New Zealand, its structure, mandates and more.
The main Wiki for the The Reserve Bank of New Zealand can be found HERE.
Other Central Banks
There are of course other central banks that you can trade around but the ones presented here are the major ones that will present traders with the majority of their trading opportunities. Once you get comfortable with how to analyze a central bank you then might want to check out some of the Scandinavian central banks or Mexico as their currencies are liquid enough to trade and are increasing in popularity with brokers and retail traders.
