Forex trading is about buying or selling one currency pair against another, with the idea of profiting from this move. Currencies are constantly moving as a result of various factors, such as technical and fundamental ones, pure speculation, and imbalances in the supply and demand levels. If there was 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, which is the US dollar. It is not yet clear whether this is a burden or a blessing for the US economy, as there are multiple advantages as well as disadvantages that come from this status. With great powers come a lot of responsibilities, and this seems to be the case for the US 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 can imagine seeing as all foreign transactions in the world need to have a corresponding US dollar element. 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 banks. The role of central banks is not to control the value of money, but to make sure that inflation is not eroding the purchasing power of their 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 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 freely float) have the strongest currencies, as it is normal for a 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 (i.e., it is 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 retail traders. Central banks of the most important economies have a mandate or a task, which is strongly related to inflation: to keep inflation below or close to 2%. 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 of around 2% implies that the economy is growing, which means that jobs are being created, which in turn means fewer people applying for unemployment benefits, which means that government spending decreases, 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 meet on a regular basis (monthly or every 6 weeks) to assess the state of the economy. It means that in a 2-day 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 6-week period that pass between two central bank meetings are interpreted as giving only 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 as such it is highly scrutinised by traders as well. The Consumer Price Index (CPI) is the economic release that shows the way inflation is moving, and it is released monthly, but also YoY (Year over Year).
There 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 shapes the monetary policy in the rest of the world as well, especially for those economies that have their debt denominated in US dollars. Coming back to the mandate, besides classical inflation, the Federal Reserve aims 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) one of the most influential and market-moving pieces of data in a trading month. The whole world is looking to see whether the United States economy has added jobs or not, and based on that outcome, speculations on the future interest rate level start.
Central Banks to Monitor
Based on each currency’s influence on the overall Forex dashboard, the most influential central banks in the world are the following:
- Federal Reserve of the United States. Also called the Fed, it holds regular meetings every 6 weeks.
- European Central Bank. Also known as ECB, the Governing Council meets every 6 weeks as well, and a press conference follows every meeting.
- Bank of England. It meets monthly, and the Monetary Policy Committee releases a press statement only if interest rates are changed.
- Bank of Japan. Also known as the BOJ, it holds monthly meetings to set the interest rate on the JPY (Japanese yen).
- Reserve Bank of Australia. The RBA meets monthly as well, to set the monetary policy for the Australian dollar and the Australian economy.
- Bank of Canada. Monthly meetings make for extreme volatility in the Canadian dollar. A press conference follows the monetary policy report.
- Reserve Bank of New Zealand. The interest rate for the Kiwi dollar is set monthly.
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 strongly influence the way the currency moves, and play a central role in the decision-making process of buying or selling a currency pair.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is Forex trading? Generalities about trading the currency market.
- Why Trade Forex?
– Advantages and disadvantages of trading the currency market; trader’s expectations; and realistic approaches to follow.
- What is a Forex Broker, and Types of Brokerage houses
– Explaining what a Forex broker is and does; how the business should be organised; and how many types of Forex brokers exist.
- Forex Brokers Types – ECN or STP?
– What are ECN and STP? How brokers deal with clients’ orders; advantages and disadvantages of the two types.
- Forex Trading – Explaining the Concept
Other Educational Materials
- “The evolution of central banks.” Goodhart, Charles. MIT Press Books 1 (1988).
- “Do central banks respond to exchange rate movements? A structural investigation.” Lubik, Thomas A., and Frank Schorfheide. Journal of Monetary Economics 54, no. 4 (2007): 1069-1087.