One of the most common refrains heard by forex traders is about the central banks manipulating currency rates. This refrain often refers to the purchase of significant amounts of foreign currencies by a central bank, but there are many other ways that a central bank can and will manipulate world currency markets. Some of these ways are not necessarily through volume trading of currencies, but rather an inherent function of a central banking authority.
The purpose of a central currency is to control the monetary policy of a particular country or region. They aim to meet several key parameters to maintain their countries financial stability. These parameters include maintaining growth rates at appropriate levels, minimizing unemployment, controlling inflation and the like.
When trading a particular currency the activities of the central bank are critical in determining its value. From a fundamental perspective, the economic conditions of each country will impact the value of their currency, and with central banks controlling most of these elements, it is their direct actions that have the power to increase or decrease the value of the currency relative to other currencies.
As a result, the impact from the central banks on the currency market is more of a byproduct of their particular role and responsibilities. In many cases the central bank will also have an eye on the currency value, should this be critical to the particular economic need of the economy.
The most common way that central markets impact the currency is through exerting control over monetary policy. Accommodative monetary policy causes an increase in the supply to markets and increase spending by lowering interest rates. The lowering of interest rates tends to make money cheaper, which lowers the relative value. In extreme cases, the central banks can undertake quantitative easing (which has recently been the case in several countries and zones like the Euro and US post GFC), through the purchase of treasury debt and bonds to stimulate the economy. Conversely, tightening policies are designed to slow the economic growth, by increasing interest rates or curbing monetary supply.
The purchase of foreign currency occurs when the central bank is looking to control the value of the currency by direct intervention in the currency markets, or shore up its currency needs. There are a variety of reasons that a central bank will undertake this action, sometimes it is to build up stores of currencies for risk control, sometimes it is looking to correct misalignments and sometimes it needs to maintain the stability of their currency for a variety of reasons. There have been notable examples of currencies intentionally ‘peging’ themselves against another currency to control the stability of their own currency.
Because of the direct impact that central banks have on their own currency, the direction that they take is of critical importance to determine the value of the currency. These policies can be understood by following the announcements of the central banks and their rate decisions, as well as keeping an eye on the important indicators that central banks monitor.
Central banks are a major player in foreign exchange markets and are a strong key to good effective trading.