Central Banks

Forex trading is about buying or selling a currency pair against another, with the idea of profiting from this move. Currencies are moving based on various aspects, like technical and fundamental ones, pure speculation and imbalances in the supply and demand levels. If there would be only one currency in the whole world, then there would be no Forex market. Forex – foreign exchange – deals with exchanging two currencies that form a currency pair. The financial system as we know it functions around the world’s reserve currency. This is the U.S. dollar. It is not clear yet if this is a burden or a blessing for the U.S. economy, as there are multiple advantages and disadvantages that come from this status. With great powers come a lot of responsibilities, and this seems to be the case for the U.S. dollar as well. When a currency is being exchanged into a different one, it needs to be cleared in dollars first. This makes the whole Forex market volatile, as one should imagine all foreign transactions in the world need to have a U.S. dollar corresponded. Having said that, it is no wonder the Forex market is the biggest one in the world. It is and probably will remain so for as long as multiple currencies exist. Different currencies around the world are influenced by their respective central bank. The role of central banks is not to control the value of money, but to make sure inflation is not eroding the purchasing power of the countries citizens and to lay down conditions for economic growth.

Central Bank’s Mandate

The currency pairs that are represented on the Forex dashboard are being split into different categories, based on different factors: liquidity, importance, etc. The biggest economies in the world (that is, economies that allow their currency to free float) are having the strongest currencies, as it is normal for the currency to reflect an economy’s strength. For example, China is in the top three of the world’s economies, but because the Chinese Yuan is not free floating (a.k.a. it is being controlled by the PBOC – People’s Bank of China), it is not possible to buy or sell it against a different currency as there is no such currency pair offered for the retail traders. Central banks of the most important economies have a mandate or a task, and this is strongly related to inflation: to keep inflation below or close to two percent. It is considered that a moderate inflation level is mandatory for a positive economic cycle. Let me guide you through what that means. Moderate inflation around two percent implies the economy is growing, which means jobs are being created, which in turns means fewer people that apply for unemployment benefits, which means the government spending is decreasing, and those remaining funds will be used to create new growth opportunities.

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Fulfilling the Mandate

To make sure the mandate is fulfilled, central banks are meeting on a regular basis (monthly or every six weeks) to assess the state of the economy. It means that in a two days meeting, the governing body of the central bank will look at the economic indicators, note the changes in inflation and in the overall economy, and set the monetary policy and the interest rate for the period ahead. That is all that matters for currency traders: the interest rate level. All the economic releases in a trading month or six weeks that pass between two central banks meetings are interpreted only to have an educated guess about what the central bank is going to do with the monetary policy and the interest rate decision at the next meeting. It means that inflation plays a key role for the central banks and therefore it is highly scrutinized by traders as well. The CPI (Consumer Price Index) is the economic release that shows the way inflation is moving and it is released monthly, but also YoY (Year over Year).

Dual Mandate

central banksThere is one central bank that has a dual mandate, though: The Federal Reserve of the United States. Besides the fact that it is the biggest central bank in the world, it is the most influential one too, as the dollar is the world’s reserve currency. In other words, the monetary policy stance in the United States is shaping up the monetary policy in the rest of the world as well, especially for those economies that have the debt denominated in U.S. dollars. Coming back to the mandate, besides the classical inflation, the Federal Reserve is aiming to create jobs. It means that the central bank will move on rates based on how the unemployment rate is changing and the number of jobs that are being created. This makes the Non-Farm Payrolls (the jobs data in the United States) being one of the most influential and market-moving piece of data in a trading month. The whole world is looking to see if the United States economy added jobs or not, and based on that outcome, speculations on the future interest rate level start.

Central Banks to Monitor

Based on their currency’s influence on the overall Forex dashboard, the most influential central banks in the world are the following:

If you combine the currencies that these central banks mentioned above represent, you’ll have the overall dashboard of the most liquid and free floating currency pairs that can be traded on the Forex market. Their decisions are strongly influencing the way the currency moves, and play a central role in the decision-making process of buying or selling a currency pair.

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