Central Banking 101 for Forex Traders

08/15/2011 7:00 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

A review of the world’s major central banks and the mandates that drive their respective policies may be useful in helping currency traders anticipate rate and policy changes that heavily impact the markets.

The one factor that is sure to move the currency markets is interest rates. Interest rates give international investors a reason to shift money from one country to another in search of the highest and safest yields.

For years now, growing interest rate spreads between countries have been the main focus of professional investors, but what most individual traders do not know is that the absolute value of interest rates is not what’s important. What really matters are the expectations for where interest rates are headed in the future.

Familiarizing yourself with what makes the central banks tick will give you a leg up when it comes to predicting their next moves, as well as the future direction of a given currency pair. In this article, we will look at the structure and primary focus of each of the major central banks and give you the scoop on the major players within these banks. We will also explain how to combine the relative monetary policies of each central bank to predict where the interest rate spread between a currency pair is headed.

Historical Interest Rate Examples

Take the performance of the New Zealand dollar (NZD)/Japanese yen (JPY) currency pair between 2002 and 2005, for example. During that time, the central bank of New Zealand increased interest rates from 4.75% to 7.25%. Japan, on the other hand, kept its interest rates at 0%, which meant that the interest rate spread between the New Zealand dollar and the Japanese yen widened a full 250 basis points. This contributed to the NZD/JPY’s 58% rally during the same period.

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On the flip side, we see that throughout 2005, the British pound (GBP) fell more than 8% against the US dollar (USD). Even though the United Kingdom had higher interest rates than the United States throughout those 12 months, the pound suffered as the interest rate spread narrowed from 250 basis points in the pound’s favor to a premium of a mere 25 basis points. This confirms that it is the future direction of interest rates that matters most, not which country has a higher current interest rate. 

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NEXT: The 8 Major Central Banks

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The 8 Major Central Banks

U.S. Federal Reserve System (The Fed)

Structure: The Federal Reserve is probably the most influential central bank in the world. With the US dollar being on the other side of approximately 90% of all currency transactions, the Fed’s sway has a sweeping effect on the valuation of many currencies. The group within the Fed that decides on interest rates is the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board plus five presidents of the 12 district reserve banks. 

Mandate: Long-term price stability and sustainable growth

Frequency of Meeting: 8 times per year

European Central Bank (ECB)

Structure: The European Central Bank was established in 1999. The governing council of the ECB is the group that decides on changes to monetary policy. The council consists of the six members of the executive board of the ECB, plus the governors of all the national central banks from the 12 euro-area countries. As a central bank, the ECB does not like surprises. Therefore, whenever it plans on making a change to interest rates, it will generally give the market ample notice by warning of an impending move through comments to the press.

Mandate: Price stability and sustainable growth. However, unlike the Fed, the ECB strives to maintain the annual growth in consumer prices below 2%. As an export-dependent economy, the ECB also has a vested interest in preventing against excess strength in its currency because this poses a risk to its export market.

Frequency of Meeting: Bi-weekly, but policy decisions are generally only made at meetings where there is an accompanying press conference, and those happen 11 times per year.

Bank of England (BoE)

Structure: The monetary policy committee of the Bank of England is a nine-member committee consisting of a governor, two deputy governors, two executive directors, and four outside experts. The BoE, under the leadership of Mervyn King, is frequently touted as one of the most effective central banks.

Mandate:To maintain monetary and financial stability. The BoE’s monetary policy mandate is to keep prices stable and to maintain confidence in the currency. To accomplish this, the central bank has an inflation target of 2%. If prices breach that level, the central bank will look to curb inflation, while a level far below 2% will prompt the central bank to take measures to boost inflation.

Frequency of Meeting:Monthly

NEXT: Bank of Japan, Swiss National Bank, and More

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Bank of Japan (BoJ)

Structure:The Bank of Japan’s monetary policy committee consists of the BoJ governor, two deputy governors, and six other members. Because Japan is very dependent on exports, the BoJ has an even more active interest than the ECB in preventing an excessively strong currency. The central bank has been known to come into the open market to artificially weaken its currency by selling it against US dollars and euro. The BoJ is also extremely vocal when it feels concerned about excess currency volatility and strength.

Mandate To maintain price stability and ensure stability of the financial system, which makes inflation the central bank’s top focus.

Frequency of Meeting Once or twice a month

Swiss National Bank (SNB)

Structure:The Swiss National Bank has a three-person committee that makes decisions on interest rates. Unlike most other central banks, the SNB determines the interest rate band rather than a specific target rate. Like Japan and the euro zone, Switzerland is also very export-dependent, which means that the SNB also does not have an interest in seeing its currency become too strong. Therefore, its general bias is to be more conservative with rate hikes.

Mandate:To ensure price stability while taking the economic situation into account

Frequency of Meeting:Quarterly

Bank of Canada (BoC)

Structure:Monetary policy decisions within the Bank of Canada are made by a consensus vote by the Governing Council, which consists of the Bank of Canada governor, the senior deputy governor, and four deputy governors.

Mandate Maintaining the integrity and value of the currency. The central bank has an inflation target of 1%-3%, and it has done a good job of keeping inflation within that band since 1998.

Frequency of Meeting 8 times a year

Reserve Bank of Australia (RBA)

Structure The Reserve Bank of Australia’s monetary policy committee consists of the central bank governor, the deputy governor, the secretary to the treasurer, and six independent members appointed by the government.

Mandate:To ensure stability of currency, maintenance of full employment, and economic prosperity and welfare of the people of Australia. The central bank has an inflation target of 2%-3% per year.

Frequency of Meeting 11 times a year, usually on the first Tuesday of each month (with the exception of January)

Reserve Bank of New Zealand (RBNZ)

Structure:Unlike other central banks, decision-making power on monetary policy ultimately rests with the central bank governor.

Mandate: To maintain price stability and avoid instability in output, interest rates, and exchange rates. The RBNZ has an inflation target of 1.5%. It focuses hard on this target, because failure to meet it could result in the dismissal of the governor of the RBNZ.

Frequency of Meeting 8 times a year

NEXT: Putting It All Together

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Putting It All Together

Now that you know a little more about the structures, mandates, and power players behind each of the major central banks, you are on your way to being able to better predict the moves these central banks may make.

For many central banks, the inflation target is key. If inflation, which is generally measured by the Consumer Price Index, is above the central bank’s target, then you know that it will have a bias toward tighter monetary policy. By the same token, if inflation is far below the target, the central bank will be looking to loosen monetary policy.

Combining the relative monetary policies of two central banks is a solid way to predict where a currency pair may be headed. If one central bank is raising interest rates while another is sticking to the status quo, the currency pair is expected to move in the direction of the interest rate spread (barring any unforeseen circumstances).

A perfect example is EUR/GBP in 2006. The euro broke out of its traditional range-trading mode to accelerate against the British pound. With consumer prices above the European Central Bank’s 2% target, the ECB was clearly looking to raise rates a few more times.

The Bank of England, on the other hand, had inflation slightly below its own target and its economy was just beginning to show signs of recovery, preventing it from making any changes to interest rates. In fact, throughout the first three months of 2006, the BoE was leaning more toward lowering interest rates than raising them. This led to a 200-pip rally in EUR/GBP, which is pretty big for a currency pair that rarely moves.

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By Kathy Lien of KathyLien.com

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