Central banks

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).

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.

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.

Major Central Banks

USA – Federal Reserve (Fed)

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.

Fed Structure

Within the Fed, there is a group of people called the Federal Open Market Committee or FOMC for short. This group consists of 1 chair, 7 governors from the Federal Reserve Board and 5 presidents from 5 of the 12 district reserve banks. The 5 presidents rotate through the 12 district reserve banks every couple years ensuring all districts get a voting seat within a 4 years cycle.

All these people combined make up the Federal Open Market Committee (FOMC) and they are definitely a big deal to the FX market so FX traders need to listen to what they say and do very carefully.

Fed Mandate

The Fed’s mandate is to achieve long-term price stability of the U.S. Dollar and ensure sustainable growth within the United States economy. Under normal circumstances, they meet to discuss and change monetary policy 8 times per year. They then release the “Minutes” from the meeting to the public one month later.

Fed Minutes

The meeting minutes are a summary of the key topics discussed and the views expressed by the individual FOMC members on those topics. These minutes are something that the market pays a lot of attention to because there are potential clues in the wording of the minutes that can give traders insights as to what type of moves the Fed might make on interest rates in the near future.

The FOMC discusses and prepares the wording of the minutes very carefully because they want to communicate very specifically to the market what they are thinking and what their intentions are. Adding or dropping certain key words can have a huge impact on market expectations of future interest rate policies. They communicate with the market in this way to try and keep price volatility as low as they can. This communication style is a form of forward guidance.

Forward Guidance

The Fed uses something called forward guidance very specifically. This simply means that they like to give the market lots of little clues and hints about what potential changes to the policy they will make and when they plan on making these changes. The idea is to minimize aggressive market reactions and control price volatility by stating things over time rather than hitting the market all at once. They do this because the more known something is to the market the less violent the reaction will be when the data is released. Remember, part of their mandate is price stability for the US Dollar so this forward guidance is an attempt to accomplish price stability.

You can read all about what the Fed is currently up to and concerned about on its website.

www.federalreserve.gov/

Europe – European Central Bank (ECB)

ECB Structure

The European Central Bank, or ECB for short, was established in 1999. The group within this central bank that decides monetary policy is called the Governing Council. The council consists of 6 members from the executive board of the ECB and the individual governors from each of the Euro area member nation central banks.

This means that all countries including Germany, France, and Spain have a spot at the table to ensure their voices are heard. This ensures that when policies are made they are designed with all Euro Zone members in mind. It’s important to make sure that no one policy is drafted that will adversely impact a specific member nation but benefits others greatly.

ECB Provides Forward Guidance

The ECB likes to provide the market with forward guidance just like the Federal Reserve does. This is their way of attempting to control price stability within the Euro currency.

The ECB’s Mandate

The ECB’s mandate is price stability and sustainable growth within the Eurozone. However, they also strive to maintain an annual CPI (consumer price index) of just below 2%. They do this because, as an export dependent economy, the ECB has a vested interest in preventing the Euro currency value from getting too high. This is because having a high Euro value could hurt the exporting companies within the Eurozone. Exporting companies are more profitable if they are paid with higher-value currencies.

ECB Meetings

The ECB meets most months of the year. When they make changes to policies they also host a press conference to go along with their statement and explain to the markets why they chose to make certain policy changes. As a trader, you know that something important is going to happen if the ECB calls a press conference with the release of their minutes because they have obviously changed some parts of their policies.

These press conferences will start with prepared remarks and typically have a question-and-answer session after. If you are day trading it’s very important to listen out for any questions about monetary policy that may happen because these questions tend to lead to unscripted answers that may be important to your trades.

www.ecb.europa.eu

United Kingdom – The Bank of England (BOE)

BOE Structure

The structure of the Bank of England includes the Monetary Policy Committee or MPC for short. The MPC is a 9 member committee consisting of a governor, 2 deputy governors, 2 executive directors, and 4 outside economic experts.

The BOE is frequently touted as one of the most effective central banks in the world because they have never once defaulted on its debt. This is impressive because they have had a rather long history on the global financial scene.

The BOE meets monthly to discuss and adjust monetary policy. If they choose to meet more than once per month then this is an indication that there are some major concerns that the BOE is presently facing. These are times that traders get some really nice trading opportunities with lower risk than normal because the price tends to move further and stronger for much longer than it would do under normal circumstances. When the market gets concerned about something the price moves tend to be cleaner and more aggressive.

BOE Mandate

Their mandate is to maintain monetary and financial stability within the United Kingdom. The BOE monetary policy mandate is to keep prices stable and to maintain confidence in their currency. They want to have confidence in their currency because the UK does business with a large number of other countries. The UK is blessed with a very favourable geographic location that is great for international trade. To accomplish this they have an inflation target of 2%.

If inflation gets higher than the 2% level the central bank will look to curb inflation to a level below 2%. This will in turn prompt them to again take measures to boost inflation back up when they have achieved their goals. Most major central banks are targeting roughly 2% growth within their economies per year.

www.bankofengland.co.uk

Japan – The Bank of Japan (BOJ)

BOJ Structure

The structure of the BOJ consists of a Monetary Policy Committee which is made up of the BOJ governor, 2 deputy governors, and 6 other members that are hand-picked by the governors.

They typically meet once per month. However, they have been known to meet twice per month on occasion if they feel there is enough concern about what is happening within the Japanese economy.

Because Japan is very dependent on exports the BOJ has an even more active interest than the ECB does in preventing its country from having an excessively strong currency. The BOJ has been known to come into the markets and artificially weaken its own currency by selling Yen against U.S. Dollars and Euros.

BOJ Jawboning

The BOJ has been known to be a particularly vocal central bank when it feels concerned about excess currency volatility and strength. It's very common to hear the members jawbone the Yen currency saying that the price is too high and if it doesn’t come down they will step in and take some action to prevent any further strengthening.

Sometimes the market will trade in line with this language and sometimes it won't. The way we can figure out how the market will trade jawboning from the BOJ is by knowing how much credibility the BOJ has with the market at that time. If they have not followed through on the last few threats then the market will probably not trade in line with the language. But if they have followed through on recent threats then you can bet that the market will listen and act very carefully. Sometimes traders just have to do what they are told!

BOJ Mandate

Its mandate is to maintain price stability and ensure the stability of the financial system. This means that inflation is the bank's top focus. At the time of this writing, Japan has had near 0% inflation for more than 2 decades so inflation is almost always the most important thing to the BOJ.

www.boj.or.jp/en

Switzerland – Swiss National Bank (SNB)

SNB Structure

The SNB is actually a publicly listed company in Switzerland where people can buy and sell their shares. This is quite unique and different from most other central banks.

The Governing Board consists of three governing members and their three deputies. These people are responsible for the operational management of the SNB.

The Bank Council oversees and controls the conduct of business by the National Bank. It consists of 11 members. Six members, including the President and Vice-President, are appointed by the Federal Council, and five by the Shareholders’ Meeting.

The Bank Council sets up four committees from its own ranks: an Audit Committee, a Risk Committee, a Remuneration Committee and an Appointment Committee.

SNB Monetary Policy

The SNB’s monetary policy strategy consists of three elements.

1. The SNB states how it defines price stability. This statement changes over time as news and events shape the economy.
2. It bases its monetary policy decisions on a medium-term inflation forecast. This can be interpreted as 6 months to 2 years.
3. It sets an operational target range for its chosen reference interest rate, which is typically based on the three-month Libor. This means that the SNB uses an interest rate band for their inflation target rather than a specific target rate like most other central banks.

The Swiss National Bank conducts the country’s monetary policy as an independent central bank. It's obligated by the Constitution to act in accordance with the interests of the country as a whole. Its primary goal is to ensure price stability while taking the prevailing economic situation into account. In so doing, it hopes to create a positive environment for economic growth.

The SNB is one of the less active central banks meeting only once every three months. However, if they have something to be concerned about they will meet more frequently.

Switzerland and Exports

Like Japan or the Euro Zone, Switzerland is also very export dependent which means that the SNB does not like seeing its currency become too strong. Therefore, its general bias is to be more conservative with interest rate hikes.

The main thing working against them in this regard is that many investors see the currency and the country as a stable thing to invest in which naturally causes the Swiss Franc to strengthen over time. At the time of this writing, the SNB has not been afraid to push investors away by taking their interest rate into negative territory. This means that they actually charge you for holding Swiss Francs. Currently, in mid 2018, the rate is sitting at -0.75%! Talk about not welcoming investment!

www.snb.ch/en

Canada – The Bank of Canada (BOC)

BOC Structure

The Bank of Canada has a similar structure to most of the other central banks. Monetary policy within the BOC is made by a consensus vote by a governing council that consists of the BOC governor, the senior deputy governor, and 4 deputy governors.

The BOC meets 8 times per year. It’s very rare that they would call a non-scheduled meeting unless there was a major concern in the financial markets. However, they did do this quite a lot in the Great Financial Crisis that kicked off in 2007. But these were extraordinary times that called for extraordinary action.

BOC Monetary Policy Mandates

Canada's monetary policy framework consists of two key components that work together:

1. The inflation control target and
2. The flexible exchange rate.

This makes their mandate to preserve the value of the currency by maintaining an inflation target between 1% and 3%.

www.bankofcanada.ca

Australia – The Reserve Bank of Australia (RBA)

RBA Structure

The RBA monetary policy committee consists of the central bank governor, the deputy governor, the secretary to the treasurer, and 6 independent members appointed by the Australian government.

They meet 11 times per year, usually on the first Thursday of each month with the exception of January.

RBA Mandates

The mandate of the RBA is to ensure the stability of the currency, maintain full employment, and economic prosperity and welfare for the people of Australia. To achieve these statutory objectives they have an inflation target of between 2% and 3% per year.

www.rba.gov.au

An interesting note is that the Australian and New Zealand currencies are sometimes referred to as the Antipodeans.

New Zealand – The Reserve Bank of New Zealand (RBNZ)

RBNZ Structure

Unlike all other major central banks that we have discussed so far, the RBNZ has a structure that gives the decision-making power on monetary policy to the central bank governor alone. The rest of the members act only as advisors to the governor.

They typically meet 8 times per year.

RBNZ Mandate

Its mandate is to maintain price stability and avoid instability of economic output, interest rates, and exchange rates.

The RBNZ has an inflation target of between 1% and 3%. It focuses hard on this target because failure to meet it could result in the governor of the RBNZ getting fired by the government.

www.rbnz.govt.nz

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.