In any given economy, the central bank is by and large charged with maintaining a healthy and stable economy in that country by controlling inflation along with other major economic indicators.
While the government or administration in any country is naturally in charge of setting the general financial and fiscal policies of the country, the central is responsible for setting the monetary policies. Through such policies the central bank can adjust the financial markets whenever it might regard it necessary.
With the truly important role of banks in various financial markets and the economy as a whole, in this article we want to shed more light on how central banks affect the forex market.
A Clearer Definition of Central Banks
Even though certain figures in central banks might be chosen by their own respective government, all things considered central banks ought to be viewed as autonomous entities that are in place to help their government in managing the big picture economy.
Obviously, as the name suggests, central banks are also often regarded to be the head or the highest ranking authority among all commercial banks in any given country. While that might be true, there are also many other responsibilities that fall within the scope of a central bank.
What Do Central Banks Do?
As one of the most prominent financial authorities in any economy, a central bank plays numerous roles, all of which are crucial for the proper management and maintenance of the said economy. Here is a list of the major responsibilities of a central bank:
Maintaining the value of currency
One of the most fundamental tasks of any central bank is to maintain and protect the value of their economy’s fiat currency. They do so by adjusting the central bank rate, among others.
Protecting the stability of financial system
Of course as the central bank and the main banking figure in the economy, central banks are in charge of regulating all the commercial banks in the country. Through the regulation and constant vigilance and observation of the commercial banks, the central banks can guarantee the proper maintenance of the whole financial system.
Financial activity and market regulation
Through setting the interest rates, the central banks can also regulate the market altogether or the financial activities that take place in an economy. The interest rate that is set by the central bank is also known as the key interest rate. The key interest rate can impact the inflation and thus indirectly impacting exchange rates and thus the forex market as a whole.
Controlling the foreign currency reserves
This is one of the responsibilities or duties of central banks that can almost directly impact the forex market. The central banks are in charge of controlling how much the reserve of foreign currencies ought to be and they also have a say in their expenditure. But more importantly, central banks also have authority to buy or sell such foreign currencies. And of course this would also have a direct impact on the exchange rates and thus the forex market. Imagine for instance, if a central bank decides to sell foreign currencies in exchange for their country’s fiat currency or vice versa, this could naturally manipulate the exchange rate.
Management of money circulation in the economy
Another immensely significant role of a central bank in any economy is to control the amount of money in circulation in that economy. Thus, central banks can inject liquidity into the economy when they see fit or constraint it for the opposite result. In this way, central banks are also able to impact the value of their fiat currency, which translates into different exchange rates in the forex market.
What Are the Consequences of Central Banks for the Forex Market?
As we discussed the roles of a central bank, it can be surmised as to how such institutions can exert their influence on the forex market. But first it must be mentioned that the most amount of influence indeed comes from the adjustment of interest rates.
This is why some of the most important news in forex that traders always pay attention to are the announcements made by the central bank or the director/chairman of the central bank regarding interest rates and their possible upcoming adjustment.
The most important example is seen in the United States. The central bank of the US, otherwise known as the Federal Reserve, has been playing with the idea of adjusting federal interest rates almost from the beginning of the Biden administration. Even their mere speculations have proven to have impacted the market, let alone actual adjustments of the federal interest rates.
Such changes in the interest rates of different economies can give encouragement and incentive to traders in order to either long or short the fiat currency in question.
Which Central Banks Are More Significant for Forex?
As a forex trader, you simply cannot keep a track of all the movements and decisions made by central banks around the world. Some central banks are more important for forex given the significance of their economy’ fiat currency and the role it plays in the forex market.
The following is a list of central banks whose economy’s fiat currencies make up the majority of all the trades that transpire in the forex market.
The Federal Reserve
This is the central bank of the US and it is considered to be the most important central bank in the world. The reason for this is that the decisions made by the Federal Reserve have the most far reaching consequences – moving far beyond US borders.
The European Central Bank (ECB)
Of course the European Central Bank is a central figure of banking with regard to the nations in the European Union. The most important role of the ECB is the authorization of the issuance of Euro. Thus being able to control the liquidity of one of the most powerful fiat currencies in the world.
The Bank of England
The Bank of England is the central bank of the UK and similar to other central banks, it is in charge of ensuring the proper circulation of liquidity and currency in the economy. And because the British Pound is an absolutely essential currency in the forex, the influence of the Bank of England is quite significant.
The Bank of Japan
The Japanese Yen is also a big player in the forex market with a huge share of trades. Not only that but the Tokyo session is also among the major forex sessions in the world. So the authority in charge of issuing and regulating Japanese Yen, i.e. the Bank of Japan, should be important for forex traders.
Central banks all over the world can have both direct and indirect impacts on the forex market. The direct effects can come from controlling the liquidity and issuing of fiat currencies, especially major fiat currencies that are important in forex. The indirect influence comes from other policies that central banks set in order to manage the economy overall.