The Role of Central Banks in the Foreign Exchange Market

If you’re involved in the financial markets, you know that the forex markets, where currencies are traded, are the largest financial market globally. 

Forex is the largest of all the markets in the world, even surpassing the stock market, with a daily trading volume of over $6.6 trillion. With a market this large, it’s no surprise to see the influence a central bank has in moving a currency’s exchange rate. 

Currency laid out displayed to represent the role of Central Banks in the Foreign Exchange Market

What Is Forex Trading?

Simply put, FX trading involves exchanging currency pairs on a trading platform in real-time. Market participants include central banks, retail investors, smaller banks and hedge funds, to name a few. 

Participants use forex pairs and the exchange to either gain a profit, hedge against inflationary risks, diversify their portfolio or for pure speculation. 

Although there are more than 180 official currencies you can buy and sell; most forex traders use major currencies. These include:

Depending on the country’s government and central bank, you’ll have currencies that have either a fixed or floating rate. Generally, countries like the major currencies use floating rates because the central banks have already created an effective and stable monetary policy. 

A currency with a floating exchange rate has currency prices determined by supply and demand relative to other currencies in the market. 

Fixed-rate currencies, on the other hand, have their exchange rate tied to another country’s currency or to the price of gold

What Is a Central Bank?

A central bank put simply, is the monetary authority of a country. They’re responsible for monitoring and regulating the banking system of their native country. 

Central banks are also responsible for developing their native country’s monetary policy and have the power to issue money. 

For example, during the 2008 financial crisis, the US Federal Reserve acted as a last resort lender to ensure banks did not face a supply shortage. In other words, central banks ensure there are sufficient reserves and are the governing power in the banking industry. 

What Role Do Central Banks Play in the Foreign Exchange Market?

Other than investment and commercial banks, central banks are the most-watched and one of the most important players. 

That’s because the central bank interest rate policies and open market operations contribute greatly to a currency’s exchange rate on the open market. 

The central bank of a country is the key figure responsible for the price of its currency on the exchange. That means any actions or verbiage from central bank members can increase or decrease a currency’s perceived value. 

Because central banks are responsible for their country’s monetary policy, they may engage from time to time in “currency interventions” to appreciate or depreciate their currency’s value. 

For example, a central bank may depreciate its own currency by essentially printing money and increasing supply during extended deflationary times. The excess cash is then used to purchase foreign currency to make exports more competitive. 

Additionally, central banks will step in during times of low and high inflation. Although central banks don’t directly control the forex market, they can influence it by raising and lowering interest rates. 

Raising and lowering interest rates affects bank liquidity and the cost of credit. For example, low-interest rates are enticing to businesses and consumers because that means it’s cheaper to borrow, thus promoting spending and promoting economic growth.

As briefly mentioned earlier, central banks control money circulation and ensure there are sufficient reserves. Central banks control the money supply by issuing or removing the liquidity of their currency. Typically stronger currencies and economies like the US have more of an international impact than others. 

They also manage foreign currency reserves by influencing their native currency’s value. Central banks can control their currency’s price by managing the value, so it’s not over or undervalued. 

What Are the Major Central Banks to Follow?

While it pays to follow all market data, especially data from the central banks of the currencies you’re trading, there are a few major central banks to pay attention to. 

The most important central banks in the forex market include:

  • The Federal Reserve (Fed)
  • The European Central Bank (ECB)
  • The Bank of England (BoE)
  • The Swiss National Bank (SNB)
  • The Bank of Japan (BoJ)
  • The Bank of Canada (BoC)

As a forex trader, you want to focus on these central banks because their currency carries weight in the global economy. Oftentimes, the policies stemming from these central banks can cause an international ripple effect. Additionally, these central banks affect the major currency pairs that are also the most liquid. 

Federal Reserve (Fed)

The Federal Reserve can be seen as the most influential central bank of all. It’s responsible for the US Dollar supply in circulation and international liquidity since many companies and countries use the US Dollar for business. 

The current chairman of the Fed is Jerome Powell. This central bank sets its interest rates through the Federal Open Market Committee (FOMC). The FOMC gathers eight times a year to discuss the current US monetary policy and to discuss future decisions. 

A vast majority of traders tend to skip FOMC days because of the volatility these days come with. Additionally, unlike other major central banks, the Fed has a decentralized structure. 

European Central Bank (ECB)

The President of the ECB is Christine Lagarde, and the central bank works to ensure the monetary cohesion of every member state that has adopted the Euro

It’s the central bank within the union that sets interest rates and, like the Fed, helps to regulate money in circulation and inflation. 

Bank of England (BoE)

The Governor of the Bank of England and Chair of the Monetary Policy Committee is Andrew Bailey. Like all the other central banks, the BoE ensures the stability of the GBP and solid banking systems within the United Kingdom.

Swiss National Bank (SNB)

The Chairman of the Governing Board of the SNB is Thomas J. Jordan, and the central bank, like the others, issues the country’s currency and determines the country’s monetary policy.  

The Swiss franc is considered to be a safe haven like the US Dollar and Japanese Yen, so the SNB works to ensure that the Swiss franc maintains price stability. 

Bank of Japan (BoJ)

The Bank of Japan has been an independent institution since 1998 and has Haruhiko Kuroda currently serving as its Governor. The bank works to contribute to the stability of its currency and sets interest rates to create a stable and liquid market. 

Interestingly, the Bank of Japan spearheaded monetary policies such as zero interest rates and quantitative easing that we still see today. 

Bank of Canada (BoC)

The Governor of the Bank of Canada is Tiff Macklem, and the central bank is a member of the Four Nations Group. This is a group made up of the Fed, BoE, RBA, and BoM that shares research and works on innovations. 

Like the other major central banks, the BoC is responsible for managing the foreign currency reserves in Canada and developing the country’s monetary policy. 

The Influence of a Central Bank

As you can see, central banks play a critical role in the forex markets, with some banks having more influence and impact than others. 

However, it’s clear that every central bank globally works to ensure their native currency’s price is stable by using various intervention strategies. As you begin your FX trading journey, it pays to keep a watchful eye on central bank announcements and to see how they influence currency fluctuations. 

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