How Central Banks Impact the Forex Market

How Central Banks Impact the Forex Market

Reading time: 8 minutes

To say central banks are important players in the foreign exchange market (or Forex market) would be an understatement. Their actions have pronounced economic consequences and can increase volatility across global exchange rates. However, a central bank is not responsible for establishing exchange rates; this is achieved in the market based on supply and demand.

What Is a Central Bank and What Does It Do?

A central bank is an independent public organisation serving to maintain economic and financial stability within an economy. Most central banks oversee the country in which they reside, though for some, like the European Central Bank, they supervise several countries. For the European Central Bank, this consists of 20 out of 27 countries in the European Union that have adopted the euro. 

A central bank has numerous responsibilities, from ensuring price stability in an economy – maintaining the rate of inflation and keeping it within reach of the central bank’s inflation target – to ensuring the economy grows steadily over time and achieves full employment. To help control prices and promote economic growth, a country’s central bank implements several monetary policy tools, such as the adjustment of short-term interest rates and the buying and selling of government securities that affect the price of borrowing. Other duties include overseeing financial institutions in the interbank market, like monitoring laws and regulations as well as supervising national payment systems and providing liquidity for commercial banks when needed. 

The following is a list of developed central banks:

  • US Federal Reserve – the Fed (the most influential central bank today with its actions having a global reach).
  • European Central Bank – ECB
  • Bank of England – BoE
  • Reserve Bank of Australia – RBA
  • Reserve Bank of New Zealand – RBNZ
  • Swiss National Bank – SNB
  • The Bank of Japan – BoJ

How do Central Banks Impact the Forex Market?

Interest Rates –

Undoubtedly, one of the most influential actions a central bank has on the Forex market is the adjustment of its interest rates or the expectation of a move.

An unexpected rate increase (decrease) can send the Forex market (and the broader financial markets) into a frenzy. One of the more recent surprises was the Swiss National Bank cutting its overnight policy rate by a quarter of a percentage point in late March 2024. This sent the Swiss franc lower against many major currencies that day. Decreasing interest rates can lessen overseas investment due to the lower yield, thus weighing on the country’s currency, while a rise in interest rates generally has the opposite effect and boosts demand for the currency.

Another market mover in the Forex market is the expectation of a rate move. Imagine the Fed voiced the possibility of raising rates if inflation continues to increase. This, alone, can increase demand for the US dollar (USD), with price movement emphasised should subsequent inflation reports demonstrate increasing price pressures.

Open Market Operations –

Open market operations, or OMOs, involve the buying and selling of government securities (largely from commercial banks) to increase or decrease the money supply. The aim is to influence borrowing and spending as well as investment in the economy. When a central bank purchases government securities, this injects money into the banking system (thus increasing the money supply). It is the same for when a central bank wants to decrease the money supply, only reverse: they sell these securities and thus remove money from the banking system. This means that central bank reserves are increased and decreased accordingly, which influences the ability of commercial banks to lend money to their customers. The buying and selling of these securities impact not only bond prices and yields but also affect currencies.

When OMOs have failed to achieve the desired result, ‘quantitative easing’ could be employed. This involves buying bonds (usually longer-term securities during a crisis) to bring down interest rates. Most developed central banks are now employing ‘quantitative tightening’: selling bonds that were purchased in previous years. Implementing quantitative easing/tightening, of course, can have broad effects on currency prices. 

Central Bank Interventions –

Central bank interventions are something all Forex traders should be aware of, as they cause drastic currency fluctuations. The intervention aims to inhibit extreme exchange rate fluctuations through buying and selling currencies in the Forex market, which tends to be conducted using central bank reserves. 

There are different forms of intervention, however. The best-case scenario for a central bank would be verbal intervention, which can sometimes be referred to as ‘jawboning’. This is essentially central banks voicing their potential actions, which often leads to currency movement. However, it does not always achieve the preferred effect, and this is when direct intervention, which is buying and selling in the Forex market, could be implemented. 

As of writing, there is speculation of a possible intervention from the Bank of Japan due to the Japanese yen (JPY) recently hitting multi-decade lows against the USD. At the time of writing, the Bank of Japan is ‘talking up’ the prospect of intervening, which has had some influence on the USD/JPY currency pair, albeit minor. Whether or not the Bank of Japan will directly intervene remains unknown at this time, but if they do support the JPY, this could send the USD/JPY and many other currency pairs 100s of pips lower in a matter of minutes. 

Currency Pegging –

Some central banks peg (fix) their currency to that of another, usually the USD – sometimes called the ‘Dollar Peg’. Interestingly, more than 60 countries around the world peg their currency to the USD. Pegging one’s currency to another is largely done to increase stability, increase competitive pricing between a nation and the country it trades with (usually its largest trading partner) and reduce exchange rate risk. However, like everything, there are risks to pegging a currency. Depending on what rate the currency is pegged at, a high or low exchange rate can cause issues. For example, a low peg means it costs more to purchase foreign goods, while an overly excessive rate could be difficult to maintain over a long period. 

There are different types of pegging. The first is a ‘hard peg’, where a currency is fixed at a specific exchange rate with another country’s currency. Another type of peg is known as a ‘soft peg’. Instead of a fixed peg, a soft peg allows the currency to fluctuate, usually within a band. This is achieved by the central bank buying and selling foreign reserves to maintain that band. 

Do pegs last forever? No. A good example of what can happen when a central bank scraps its peg is the Swiss National Bank removing its peg to the euro at 1.20 Swiss francs per euro in 2015. This announcement sent the Swiss franc about 30% higher in the immediate aftermath.

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Source - database | Page ID - 39408

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