Table of Contents

Lesson 5: Central Banks and Interest Rates

5.2 The Role of Central Banks

Central Banks Set Interest Rates

Since central banks, also known as reserve banks, play the crucial role of setting interest rates they need to be followed and studied by a fundamental (and even technical) Forex trader. Central banks want to achieve financial stability of their currency (i.e. battle inflation) and maintain overall economic growth in their country. Their primary responsibility is to oversee the monetary policy of a particular country or group of countries (in the case of the European Union). Monetary policy refers to the various efforts made to effectively control and manage the amount of money circulating within a nation. Skilled investors are able to properly identify which currency will experience an increase in interest rates based upon a central bank’s statements and incoming financial data. Those investors that are correct in their speculations can predict how the respective currencies should move, and as a result should be able to take the proper long or short positions.

Central Bank’s Role in Fighting Inflation

Central banks act in ways to lessen the effects of inflation on an economy. Inflation refers to a rise in price levels which causes a fall in the purchasing power of a currency. Inflation accounts for an entire basket of goods and services, not just an increase in the price of one item. Monitoring prices of a particular basket is known as indexing and provides a reliable method of tracking inflationary movement.

Inflation’s effects can be felt on just about everyone within a society regardless of whether one engages in trading or not. At times of high inflation, employees will demand more money for their work as the previous hourly wage no longer reflects the same value. In order to pay their employees more, businesses have to raise their prices so that they can also manage to raise the wages of its employees.

Inflation and Oil (Example)

Inflation Interestingly, inflation can be set off by the increase in price of just one crucial item (food or energy) as well. An example of a volatile commodity that can cause inflation is oil. An increase in the price of oil would cause many other items that use it as an input in the production process (such as gasoline) to also increase in price and therefore begin the inflationary process. Inflation poses a problem to the population because it erodes people’s wealth and standard of living as their bank accounts and wages seem to diminish while prices get higher. The purchasing power of the currency decreases and the currency loses strength. Therefore inflation’s erosive nature necessitates the actions taken by the central bank.

Affects of Inflation on Interest Rates and Investment

If inflation is a concern then the central bank will raise interest rates to appease the inflationary pressure. Higher interest rates will cause inflation to slow because it will cost more for companies and consumers to borrow from banks to fund either investment spending or consumption (i.e. for consumers it will be harder to refinance a mortgage on a house to free up spending money). With more restrictive access to money, economic activity slows down and so do inflationary pressures.

The higher interest rate will cause the currency to appreciate in the eyes of investors, both domestic and foreign, as they will benefit from a higher yield on the country's assets. If the currency is now appreciating relative to other currencies, then Forex traders will buy into it in order to trade with the trend, sending even more money towards that economy.

It is therefore a delicate balance that central banks have to strike. They would like higher interest rates to strengthen the currency and promote foreign investment, but they must be aware that higher interest rates hurt domestic businesses and consumers that rely on borrowing money from banks.

In the following pages, we shall look at an example of interest rates and central banks, and their impact on the Forex market at work.