The one factor that is sure to move the currency markets is interest rates.
Interest rates give international investors a reason to shift money from one
country to another in search of the highest and safest yields. For years now,
growing interest rate spreads between countries have been the main focus of
professional investors, but what most individual traders do not know is that
the absolute value of interest rates is not what's important - what really
matters are the expectations of where interest rates are headed in the future.
Tutorial: Popular Forex Currencies
Familiarizing yourself with what makes the central banks tick will give you a
leg up when it comes to predicting their next moves, as well as the future
direction of a given currency pair. In this article, we look at the structure
and primary focus of each of the major central banks, and give you the scoop on
the major players within these banks. We also explain how to combine the
relative monetary policies of each central bank to predict where the interest
rate spread between a currency pair is headed. (To learn more, check out What
Are Central Banks?)
Examples
Take the performance of the NZD/JPY currency pair between 2002 and 2005, for
example. During that time, the central bank of New Zealand increased interest
rates from 4.75% to 7.25%. Japan, on the other hand, kept its interest rates at
0%, which meant that the interest rate spread between the New Zealand dollar
and the Japanese yen widened a full 250 basis points. This contributed to the
NZD/JPY's 58% rally during the same period.
Figure 1
On the flip side, we see that throughout 2005, the British pound fell more than
8% against the U.S. dollar. Even though the United Kingdom had higher interest
rates than the United States throughout those 12 months, the pound suffered as
the interest rate spread narrowed from 250 basis points in the pound's favor to
a premium of a mere 25 basis points. This confirms that it is the future
direction of interest rates that matters most, not which country has a higher
interest rate.
Figure 2
The Eight Major Central Banks
U.S. Federal Reserve System (The Fed)
Structure - The Federal Reserve is probably the most influential central bank
in the world. With the U.S. dollar being on the other side of approximately 90%
of all currency transactions, the Fed's sway has a sweeping effect on the
valuation of many currencies. The group within the Fed that decides on interest
rates is the Federal Open Market Committee (FOMC), which consists of seven
governors of the Federal Reserve Board plus five presidents of the 12 district
reserve banks.
Mandate - Long-term price stability and sustainable growth
Frequency of Meeting - Eight times a year
European Central Bank (ECB)
Structure - The European Central Bank was established in 1999. The governing
council of the ECB is the group that decides on changes to monetary policy. The
council consists of the six members of the executive board of the ECB, plus the
governors of all the national central banks from the 12 euro area countries. As
a central bank, the ECB does not like surprises. Therefore, whenever it plans
on making a change to interest rates, it will generally give the market ample
notice by warning of an impending move through comments to the press. (Learn
more in Why Interest Rates Matter For Forex Traders.)
Mandate - Price stability and sustainable growth. However, unlike the Fed, the
ECB strives to maintain the annual growth in consumer prices below 2%. As an
export dependent economy, the ECB also has a vested interest in preventing
against excess strength in its currency because this poses a risk to its export
market.
Frequency of Meeting - Bi-weekly, but policy decisions are generally only made
at meetings where there is an accompanying press conference, and those happen
11 times a year.
Bank of England (BoE)
Structure - The monetary policy committee of the Bank of England is a
nine-member committee consisting of a governor, two deputy governors, two
executive directors and four outside experts. The BoE, under the leadership of
Mervyn King, is frequently touted as one of the most effective central banks.
Mandate - To maintain monetary and financial stability. The BoE's monetary
policy mandate is to keep prices stable and to maintain confidence in the
currency. To accomplish this, the central bank has an inflation target of 2%.
If prices breach that level, the central bank will look to curb inflation,
while a level far below 2% will prompt the central bank to take measures to
boost inflation.
Frequency of Meeting - Monthly
Bank of Japan (BoJ)
Structure - The Bank of Japan's monetary policy committee consists of the BoJ
governor, two deputy governors and six other members. Because Japan is very
dependent on exports, the BoJ has an even more active interest than the ECB
does in preventing an excessively strong currency. The central bank has been
known to come into the open market to artificially weaken its currency by
selling it against U.S. dollars and euros. The BoJ is also extremely vocal when
it feels concerned about excess currency volatility and strength.
Mandate - To maintain price stability and to ensure stability of the financial
system, which makes inflation the central bank's top focus.
Frequency of Meeting - Once or twice a month
Swiss National Bank (SNB)
Structure - The Swiss National Bank has a three-person committee that makes
decisions on interest rates. Unlike most other central banks, the SNB
determines the interest rate band rather than a specific target rate. Like
Japan and the euro zone, Switzerland is also very export dependent, which means
that the SNB also does not have an interest in seeing its currency become too
strong. Therefore, its general bias is to be more conservative with rate hikes.
Mandate - To ensure price stability while taking the economic situation into
account
Frequency of Meeting - Quarterly
Bank of Canada (BoC)
Structure - Monetary policy decisions within the Bank of Canada are made by a
consensus vote by Governing Council, which consists of the Bank of Canada
governor, the senior deputy governor and four deputy governors. (For more on
the Canadian dollar, check out The Canadian Dollar: What Every Forex Trader
Needs To Know.)
Mandate - Maintaining the integrity and value of the currency. The central bank
has an inflation target of 1-3%, and it has done a good job of keeping
inflation within that band since 1998.
Frequency of Meeting - Eight times a year
Reserve Bank of Australia (RBA)
Structure - The Reserve Bank of Australia's monetary policy committee consists
of the central bank governor, the deputy governor, the secretary to the
treasurer and six independent members appointed by the government.
Mandate - To ensure stability of currency, maintenance of full employment and
economic prosperity and welfare of the people of Australia. The central bank
has an inflation target of 2-3% per year.
Frequency of Meeting - Eleven times a year, usually on the first Tuesday of
each month (with the exception of January)
Reserve Bank of New Zealand (RBNZ)
Structure - Unlike other central banks, decision-making power on monetary
policy ultimately rests with the central bank governor.
Mandate - To maintain price stability and to avoid instability in output,
interest rates and exchange rates. The RBNZ has an inflation target of 1.5%. It
focuses hard on this target, because failure to meet it could result in the
dismissal of the governor of the RBNZ.
Frequency of Meeting - Eight times a year
Putting It All Together
Now that you know a little more about the structure, mandate and power players
behind each of the major central banks, you are on your way to being able to
better predict the moves these central banks may make. For many central banks,
the inflation target is key. If inflation, which is generally measured by the
Consumer Price Index, is above the central bank's target, then you know that it
will have a bias toward tighter monetary policy. By the same token, if
inflation is far below the target, the central bank will be looking to loosen
monetary policy. Combining the relative monetary policies of two central banks
is a solid way to predict where a currency pair may be headed. If one central
bank is raising interest rates while another is sticking to the status quo, the
currency pair is expected to move in the direction of the interest rate spread
(barring any unforeseen circumstances).
A perfect example is EUR/GBP in 2006. The euro broke out of its traditional
range-trading mode to accelerate against the British pound. With consumer
prices above the European Central Bank's 2% target, the ECB was clearly looking
to raise rates a few more times. The Bank of England, on the other hand, had
inflation slightly below its own target and its economy was just beginning to
show signs of recovery, preventing it from making any changes to interest
rates. In fact, throughout the first three months of 2006, the BoE was leaning
more toward lowering interest rates than raising them. This led to a 200-pip
rally in EUR/GBP, which is pretty big for a currency pair that rarely moves.
Figure 3
Curious to learn more about central banks and monetary policy? Check out
Formulating Monetary Policy and the Federal Reserve Tutorial.
by Kathy Lien
How The U.S. Government Formulates Monetary Policy
A monetary policy is the means by which a central bank (also known as the
"bank's bank" or the "bank of last resort") influences the demand, supply and,
hence, price of money and credit in order to direct a nation's economic
objectives. Following the Federal Reserve Act of 1913, the Federal Reserve (the
U.S. central bank) was given the authority to formulate U.S. monetary policy.
To do this, the Federal Reserve uses three tools: open market operations, the
discount rate and reserve requirements.
Within the Federal Reserve, the Federal Open Market Committee (FOMC) is
responsible for implementing open market operations, while the Board of
Governors looks after the discount rate and reserve requirements.
The Federal Fund Rate
The three instruments we mentioned above are used together to determine the
demand and supply of the money balances that depository institutions, such as
commercial banks, hold at Federal Reserve banks. The dollar amount placed with
the Federal Reserve in turn changes the federal fund rate. This is the interest
rate at which banks and other depository institutions lend their Federal Bank
deposits to other depository institutions - banks will often borrow money from
each other to cover their customers' demands from one day to the next. So, the
federal fund rate is essentially the interest rate that one bank charges
another for borrowing money overnight. The money loaned out has been deposited
into the Federal Reserve based on the country's monetary policy.
The federal fund rate is what establishes other short-term and long-term
interest rates and foreign currency exchange rates. It also influences other
economic phenomena, such as inflation. To determine any adjustments that may be
made to monetary policy and the federal fund rate, the FOMC meets eight times a
year to review the nation's economic situation in relation to economic goals
and the global financial situation.
Open Market Operations
Open market operations are essentially the buying and selling of
government-issued securities (such as U.S. T-bills) by the Federal Reserve. It
is the primary method by which monetary policy is formulated. The short-term
purpose of these operations is to obtain a preferred amount of reserves held by
the central bank and/or to alter the price of money through the federal fund
rate.
When the Federal Reserve decides to buy T-bills from the market, its aim is to
increase liquidity in the market, or the supply of money, which decreases the
cost of borrowing, or the interest rate.
On the other hand, a decision to sell T-bills to the market is a signal that
the interest rate will be increased. This is because the action will take money
out of the market (too much liquidity can result in inflation), therefore
increasing the demand for money and its cost of borrowing.
The Discount Rate
The discount rate is essentially the interest rate that banks and other
depository institutions are charged to borrow from the Federal Reserve. Under
the federal program, qualified depository institutions can receive credit under
three different facilities: primary credit, secondary credit and seasonal
credit. Each form of credit has its own interest rate, but the primary rate is
generally referred to as the discount rate.
The primary rate is used for short-term loans, which are basically extended
overnight to banking and depository facilities with a solid financial
reputation. This rate is usually put above the short-term market-rate levels.
The secondary credit rate is slightly higher than the primary rate and is
extended to facilities that have liquidity problems or severe financial crises.
Finally, seasonal credit is for institutions that need extra support on a
seasonal basis, such as a farmer's bank. Seasonal credit rates are established
from an average of chosen market rates.
Reserve Requirements
The reserve requirement is the amount of money that a depository institution is
obligated to keep in Federal Reserve vaults in order to cover its liabilities
against customer deposits. The Board of Governors decides the ratio of reserves
that must be held against liabilities that fall under reserve regulations.
Thus, the actual dollar amount of reserves held in the vault depends on the
amount of the depository institution's liabilities.
Liabilities that must have reserves against them include net transactions
accounts, non-personal time deposits and euro-currency liabilities; however, as
of December 1990, the latter two have had reserve ratio requirements of zero
(meaning no reserves have to be held for these types of accounts).
Conclusion
By influencing the supply, demand and cost of money, the central bank's
monetary policy affects the state of a country's economic affairs. By using any
of its three methods - open market operations, discount rate or reserve
requirements - the Federal Reserve becomes directly responsible for prevailing
interest rates and other related economic situations that affect almost every
financial aspect of our daily lives.
by Reem Heakal