The forex market is the largest and most liquid of the capital markets, with more than 7.5 trillion dollars per day in daily turnover. There are dozens of different market participants. Traders in the forex market include speculators, corporate treasurers, hedge funds, mutual funds, commercial banks, and central banks. Each player in the forex market plays a specific role.
Central banks provide liquidity and monitor and regulate the currency markets while overseeing the banking industry. Central banks can intervene in the forex markets if the currency’s value impacts a country’s market operations. The central bank’s goal is to ensure that the sovereign currency is not overvalued or undervalued. There are many tools that a central bank can use to impact the forex markets. The three distinct ways that a central bank impacts the forex markets are by altering short-term borrowing rates, conducting money market operations, and direct intervention.
What is a Central Bank?
The first central banks date back to the 17th century. The first known central banks were the Bank of England and Swedens Riksbank. The central banks at that time were the lenders of last resort and made it easier for governments to grow, conduct military operations and enrich the interests of the governments. In the United States, the central bank, the Federal Reserve, was established in 1913 by the U.S. Congress. The Fed is independent of the U.S. Congress and oversees the central bank.
A central bank is a financial institution that controls the distribution and production of currency and credit within a nation or region. For example, in the United States, which is a country, the Federal Reserve is the Central Bank. In the European Union, the European Central Bank is the central bank for that region. Central Banks usually have a mandate as independent institutions to control the currency and monitor price stability. Some central banks are expected to maximize employment as well.
There are several ways a central bank will alter the course of the forex market. A central bank will control part of monetary policy, including short-term borrowing rates and money supply. To change the money supply, a central bank will perform overnight operations where it borrows and borrows. Central banks will determine the available credit and reserve requirements of banks in the nation or region that it oversees. A central bank is also considered the lender of last resort. When a financial institution or a government is in trouble, the central bank will come to the rescue.
What is the Lender of Last Resort
The lender of last resort is usually a financial institution that can offer loans to other institutions when no other bank or financial institution will offer loans. If a company or group is experiencing economic collapse, a lender of last resort might be needed to bail out the company. The country usually backstops the emergency credit provided by a central bank. Some might argue that having a lender of last resort encourages risky behavior, as companies or banks know a central bank can bail them out.
When a commercial bank borrows capital from the lender of last resort, it signals to others that it might be in trouble. A lender of last resort can prevent a run on a bank by lending a bank that is in trouble capital, so depositors will try to train the bank of its money and make the institution illiquid.
How Do Central Banks Impact the Forex Market with Monetary Policy?
A central bank can impact the direction of an exchange rate using several tools. The three most common ways to impact forex trading are changing short-term borrowing rates, engaging in money market operations, and direct intervention.
A central bank can impact short-term borrowing rates by changing the rate at which each bank lends to one other. In the United States, this rate is called the Fed Funds rate. When the Fed changes the Fed Fund rate, the rate that commercial banks lend to one another changes.
The short-term borrowing rate of a central bank plays an essential role in the forex market. These rates are used as the basis for lending rates used by commercial banks to their borrowers. The interest rates make up the forward rates used in the forex market. Traders in the forex market will use the difference between the two currencies borrowing rates to construct the forward points used to create the forward rate.
Recall there are two different rates used in forex trading. The spot rate is a rate that is used to transact an exchange rate where the delivery of each currency occurs in two business days. The exchange rate is the forward rate for any period beyond two business days.
The difference between two countries’ interest rates is called the interest rate differential. As the interest rate differential changes, the forward points, and the forward rate will change. For example, suppose the U.S. interest rate increases from 3% to 4% while the European interest rate remains the same. In that case, the differential will favor the dollar as the rate will increase to borrow and lend dollars relative to the European Union. As the interest rate moves in favor of a currency, that currency will generally increase in value. The upshot is that as a central bank changes its short-term borrowing rate, it can impact the currency’s value. The currency’s value can rise when a central bank increases rates at an accelerating rate. When a central bank decreases interest rates at a quick pace, the value of the exchange rate can decline.
A central bank can also impact the forex market by using money market operations and buying and selling government securities. When a central bank buys overnight funds or government securities, it increases liquidity and pushes up the securities’ value. Since yields and price move in the opposite direction, the central bank reduces yields when it buys securities and overnight funds. The opposite occurs when the central bank sells overnight funds and government securities. By changing the short-term rate, the central bank will alter the forward rate and impact the forex market.
Another operation that a central bank can conduct is direct intervention. Intervention is a monetary policy operation where the central bank buys and sells currency against its domestic currency. The goal is to weaken or strengthen the central bank’s domestic money artificially. There are several reasons why a central bank would intervene in the currency market. The objectives might include controlling inflation or maintaining competitiveness.
When a central bank helps increase the exchange rate of its home currency, it makes goods more expensive to purchase by foreigners and reduces demand which can help control inflation. When a central bank reduces the exchange rate of its home currency, it can make its exports more competitive.
A central bank might also want to reduce the volatility in the currency markets. Suppose a country’s currency is attacked due to military operations or civil unrest. In that case, a central bank might purchase its domestic currency to ensure its value and attempt to avoid a mass exodus. Historically, direct intervention in the currency markets only works for a short period. The efforts of the central bank might reduce short-term volatility. Still, they will generally not be able to change the underlying fundamentals that drive an exchange rate’s direction.
The Bottom Line
The upshot is that there are many ways that a central bank will impact the forex market. Most of the time, a central bank is focused on inflation and employment. Its efforts to increase or decrease short-term interest rates are geared to buoying or contracting economic growth and inflation, and the byproduct of these measures will impact the forex market.
There are some instances where the central bank wants to change the direction of an exchange rate or reduce the volatility in the forex market. There are three distinct ways that a central bank can impact the forex market. The first is to alter short-term interest rates. The second is to perform money market operations or buy and sell government securities. The last way is direct intervention.
A central bank might want to impact the forex market to reduce inflation or increase competitiveness. They also might want to minimize volatility because of civil unrest or military action. While short-term interest rate changes and money market operations can alter the course of an exchange rate over the long term, direct intervention usually only lasts for short periods. Direct intervention is best at reducing volatility in the forex markets.