In the Forex trading world, the thing that matters the most for a currency is the interest rate. This is what drives the Forex market, and without it things would be quite boring. Central banks strive for price stability, but this doesn’t mean that they want a fixed 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 the central bank. In every jurisdiction, there is a central bank that governs the economy. Capitalism is built on an open market, and on the independence of the institutions that govern this market. Central banks in capitalistic countries are independent and do not respond to any form of government, and hence they should not be influenced by political decisions. The major currency pairs that are part of the Forex dashboard move based on the monetary policy decisions of their corresponding, independent, central banks. Even the ones that are not directly correlated do that. The global financial system is organised in such a way that it is difficult to change a monetary policy in a major part of the world, such as in the Eurozone, for example, without it having secondary effects in the United States, the United Kingdom, Japan, or the rest of the world. The reverse is true as well: when the interest rate or the overall monetary policy changes in the United States, the course of money flows changes the whole world over.
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What Forms a Central Bank’s Mandate?
A mandate represents the mission of a central bank. In the same way that any serious company in this world has a mission, the central bank has a mandate, and to fulfil that mandate, it supervises the economy daily. From time to time, in an organised fashion, the governing body of the central bank meets 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 aimed in the same direction, but, most of the time, growth is stimulated. Interest rates are only the result of a set of monetary policy tools. The central banks meet on a regular basis, look at the change in the economic indicators since the last time they met, 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 recovery. If, on the other hand, the economy is overheating or advancing at a faster pace than desired, the central bank will administer the right medicine to avoid a hard landing. Part of the monetary policy is the language central banks use as well. After the governing body has assessed 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 meets again. In the Eurozone, it is called the Governing Council’s statement, in the United States 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 monetary policy. High-frequency trading, and trading algorithms as well, react violently to any sudden change. Because the financial system is interconnected, if central bankers are 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 only read “keeping the rates low”. Dropping the “for an extended period of time” wording is a hawkish statement from that central bank, and so bullish for the currency. Robots and trading algorithms will see that in the 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 Consumer Price Index (CPI ). This is a monthly or yearly release, and it is watched closely by all market participants. There’s 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, but for now, let’s focus on the mandate itself. A central bank’s mandate is to keep inflation below or close to 2%. 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 to be growing at a healthy pace. Changes in inflation will be met with changes in the monetary policy.
An inflation-based mandate is the case in the Eurozone, the United Kingdom, Japan, and several others. 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 (the Fed). The Fed’s mandate is not only to keep inflation below or close to 2%, 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 as to stimulate jobs creation and keep inflation at bay, below or close to 2%. 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 complete. and chances are that the tone of the next FOMC statement will be hawkish. That means the US dollar will be bought. The opposite is true as well, and 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 a very slow one. Ranges dominate, 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, such as oil and other factors, transitory or not, that may influence prices at any one moment in time.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What Forex trading is, and generalities about trading the currency market. - Why Trade Forex?
– Advantages and disadvantages of trading the currency market; traders’ expectations; and a realistic approach to follow - Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions; their importance, ranking, etc. - Forex Brokers Types – ECN or STP?
– What is ECN? What is STP? How brokers deal with clients’ orders; and advantages and disadvantages of the two types. - What Makes a Good Forex Broker?
– Things to consider when deciding what broker to trade with, and the factors that carry the most weight in the decision-making process. - Why Trade with a Regulated Forex Broker?
– What regulation is for a brokerage house; why it is important; and things to look for, such as how to check whether 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).
