Trading Academy

Lesson 31

Central Banks – Behind the Scenes

Probably the most influential factor on a currency’s value is the policy set by a country’s central bank. Its objective is to influence domestic rates, which in turn influence overall economic activity. Lower interest rates generally stimulate borrowing, investment and consumption, while higher interest rates reduce borrowing and consumption.

Currency intervention entails a central bank buying or selling its own currency to adjust the exchange rate. This is a way to control inflation and demand for imports and exports, and it also assures exchange-rate stability.

This intervention means different things to different types of traders:

  • for short-term traders, intervention might mean large intraday moves, sometimes to the tune of 150 – 200 pips in a matter of minutes.
  • for medium/long-term traders, intervention might signal a change of trend if the bank is shifting its stance and sending a different message to the market.

The monetary policy that central banks adopt falls into two big categories: expansionary or restrictive.

Expansionary monetary policy – also known as accommodative, it is aimed at stimulating economic growth, by means of lowering interest rates. Another measure is the increase in money supply, which achieves the lowering of borrowing costs.

Restrictive monetary policy – aimed at slowing economic growth/fighting inflation by raising interest rates. This policy is also known as “tightening” and is applied at times when the economy is expanding too rapidly. With too much money chasing too few goods, prices begin to rise and central banks now have to stave off the rising inflation.

With regards to the specifics of interventions, there are two kinds of foreign exchange interventions: sterilized and unsterilized.

Sterilized intervention – this will not have an impact on the money supply. It is “sterilized” because, aside from outright buying or selling of the currency, it also involves an additional step: a sale of government securities that offsets the reserve addition that occurs due to the intervention. The impact of such a move is usually short to medium-term.

Unsterilized intervention – this type of intervention refers to buying or selling the national currency against a foreign currency. The impact can be seen at all levels of the economy, aside from the one seen in the foreign exchange market. As a consequence, other adjustments must be made (in interest rates, in prices etc.). This kind of intervention brings a long-term effect.

Keep in mind: following the activity of central bank should be a top priority for all traders. For this, it is advisable to follow the data published on the various Forex news outlets, watch live coverage of monetary policy meetings and speeches, and follow trusted analysts and their expectations.


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