Fundamental Analysis – Central Banks Mandates
In the Forex trading world, the thing that matters the most for a currency is the interest rate. This is what moves the Forex market, as otherwise, things would be quite boring. Central banks are striving for price stability, but this doesn’t mean that they want a fix currency rate. Rather, it means that they want the currency to be stable and not to lose value or appreciate in a meaningless way. The interest rate is set by a central bank. In every jurisdiction, there is a central bank that governs over an economy. Capitalism is built on open market and independence of the institutions that govern this market. Central banks in capitalistic countries are independent, they do not respond to any form of government, hence they should not be influenced by political decisions. The major currency pairs that are part of the Forex dashboard are moving based on the monetary policy decisions of their corresponding, independent, central banks. Even the ones that are not directly correlated are doing that. The global financial system is organized in such a way it is difficult to change a monetary policy in a major part of the world, like in the Eurozone, for example, without having secondary effects in the United States, United Kingdom, Japan, or the rest of the world. And the other way around is true as well: when the interest rate or the overall monetary policy is changing in the United States, the whole world is changing the course of money flows is changing.
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What Makes a Central Bank’s Mandate
A mandate represents the mission of a central bank. Like any serious company in this world is having a mission, the central bank has a mandate. To fulfill the mandate, the central bank is supervising the economy daily. From time to time, in an organized fashion, the governing body of the central bank is meeting to assess the changes in the economy and to set the monetary policy for the period to come.
What is Monetary Policy
The monetary policy set by a central bank is a set of economic tools designed to stimulate an economy. They are not always aiming in the same direction, but, most of the times, growth is stimulated. Interest rates are only the result of a set of monetary policy tools. The central banks are meeting on a regular basis, look at the change in the economic indicators since the last time they meet and set the monetary policy for the period ahead. If you want, central banks are like doctors for an economy, trying to constantly treat the patient: if the economy is in bad shape, the central bank will change the monetary course in such a way as to stimulate the recovery. If the economy, on the other hand, is overheating or advancing at a faster pace than desired, the central banks will administer the right medicine to avoid a hard landing. Part of the monetary policy is the language central banks use too. After the governing body is assessing the shape of the economy, it issues a statement. This statement has different names around the world, but it shows the same thing: the verdict or the treatment to be applied for the period ahead until the governing body is meeting again. In the Eurozone, it is being called the Governing Council’s statement, in the United States it is the Federal Open Market Committee statement, and so on. The statement is subject to interpretation, based on the wording used. Central bankers must be very careful when choosing the words to express a change in the monetary policy. High-frequency trading and trading algorithms as well are reacting violently to any sudden change. Because the financial system is interconnected, if central bankers will be blunt in their monetary policy and an overall market transmission mechanism, disruptions will hurt the system. To avoid that, when monetary policy is about to shift, central bankers change the wording in their statement. For example, instead of “keeping the rates low for an extended period of time”, the new statement may read only “keeping the rates low” Dropping the “for an extended period of time” wording is a hawkish statement from that central bank and bullish for the currency. Robots and trading algorithms will see that in a blink of an eye and the Forex market will react instantly.
Defining a Mandate
Any central bank’s mandate refers to price stability. Price stability, in turn, refers to inflation. In economic terms, inflation is represented by the CPI (Consumer Price Index). This is a monthly or yearly release, and it is watched closely by all market participants. More about inflation and its importance in the overall monetary policy decision to be found in the next article here on the Trading Academy project. For now, let’s focus on the mandate itself. A central bank’s mandate is to keep inflation below or close to two percent. An inflation level considered to be a normal one is when inflation is anywhere between 1.8% and 2.2%. At such a rate, the economy is perceived as growing at a healthy pace rate. Changes in inflation will be met with changes in the monetary policy.
An inflation based mandate is the case in the Eurozone, United Kingdom, Japan, and the list can go on. However, there is one central bank in the world that has a dual mandate. Funny or not, coincidence or not, this is the biggest and the most influential central bank in the world: The Federal Reserve of the United States (Fed). Fed’s mandate is not only to keep inflation below or close to two percent but also to create jobs. This is a tough task because the central bank must find a balance in its monetary policy in such a way to stimulate jobs creation and keep inflation at bay, below or close to two percent. Such a mandate is the reason why the jobs data in the United States is closely watched by traders around the world. A strong employment number or strong overall jobs data will make the second part of the Fed’s mandate completed and chances are the tone of the next FOMC statement will be hawkish. That means the U.S. dollar will be bought. The opposite is true as well. Because of that, no one is willing to take a chance when the Non-Farm Payrolls (the main jobs indicator) is about to be released. As a rule of thumb, the Non-Farm Payrolls is released every first Friday of the trading month, and this makes the trading week until that Friday to be a very slow one. Ranges are dominating as a break is imminent. The next article will deal with the role of inflation in setting the monetary policy and how interest rates are correlated with inflationary levels. Moreover, we’ll look at various inflationary causes, like oil and other factors, transitory or not, that may influence prices at any one moment of time.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is forex trading, generalities about trading the currency market.
- Why Trading Forex?
– Advantages and disadvantages of trading the currency market, what are trader’s expectations and what is a realistic approach to follow
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
- What Makes a Good Forex Broker?
– Things to consider when deciding what broker to trade with. What are the factors that weigh the most in the decision-making process?
- Why Trading with a Regulated Forex Broker?
– What is regulation for a brokerage house, why it is important, things to look for, how to check if the broker is telling the truth, etc.
Other Educational Materials
- What should central banks do? Mishkin, F.S., 2000.
- “Financial stability frameworks and the role of central banks: lessons from the crisis.” Nier, Erlend W. (2009).