How Do Central Banks Affect the Forex Markets?

08/05/2008 12:00 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor,

How the Fed and other central banks affect currency values is an unknown to many forex traders. This is an important topic and is not as mysterious as many traders think. In this video I will show you the primary tool G10 central banks use (debt) to manage cash rates.

Central banks manage the cash rate (aka the Fed funds rate in the US) because it impacts, capital flows, growth, inflation and ultimately employment, all of which are important to economic stability. However the cash rate is an imperfect tool and often leaves the central bank in a dilemma of conflicting directives. For example, right now the Reserve Bank of Australia is trying to simultaneously manage risks to economic growth, which can be done by lowering interest rates and inflating the currency while trying to keep a cap on consumer price inflation itself. That conflict is not easy to resolve. The cash rate is lowered by inflating the currency but that is likely to increase consumer inflation. Can you see the conflict here? The real issue is trying to determine which factor (inflation or growth) is the biggest economic problem. In other words, is the risk to growth greater than the economic risks of inflation? That decision is ultimately what will likely drive the Fed's and the RBA's decisions this week.

Watch the video now

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