Central Banking – Forex Market Effects
Around the globe, there are many Central Banks which are used by Countries to aid their management of the commercial banking currencies and interest rates. Central banks have been around for a long time and paper money issued for the 1st time over 1000 years ago in Asia. So it started many years ago and has been fine tuned over a long period of time which is how we arrived at the current high tech banking systems of the modern day.The most influential Central bank is the United States Federal Reserve, also known in the trading world as the Fed. Then you have the Bank of England & European Central Bank, with others such as the reserve bank of Australia and Bank of Canada.
The Federal Reserve
In the United States, the Central bank was first developed as far back as the 1700's. During the Revolutionary war in 1775, Congress had meetings intent on developing a plan to for a national currency to develop credit to fund the conflict.The ‘Continental' value, relied entirely on the future collections of tax of the future independent nation. As the revolution drew on with no conclusion, overprinting and counterfeiting brought about the devaluation and ultimate demise of the Continental currency. When the constitutional convention of 1787 convened, one of the first priorities was the discussion of the current financial system. As of 1791 the First Bank of the United States was issued its original charter.
Today in our modern Society, The United States Central Bank system is run by the Federal Reserve. The Fed was developed with the intent of providing a safer and more stable monetary system by congress in early 1913. The goals of the Federal Reserve are achieved by conducting monetary policies and regulating banks.
The Federal Reserve system of today was primarily created to avoid panic among banks in the United States. In 1907, an issue came to light which came to be known as “Bankers Panic”. The New York Stock Exchange collapsed, shedding 50% from the highs of the previous year. Once people learned of this and that their savings were unsafe at their local banks, there was a mass rush to withdrawal their money, which in turn created a huge capital shortfall.
The United States Federal Reserve now has things in place to ensure no repeat of this fiasco. If problems occur at a local bank, money can be loaned to them by the Federal Reserve at a discounted rate. Banks then ensure the run is met, and then return their debt back to the Federal Reserve. This is just one example of many contingencies that the Fed have put in place to ensure the regular running of bank depositories and market trading.
Here is another example of a tool the fed use to achieve its targets. The United States Monetary policies are actions that the Federal Reserve takes to ensure the supply of money is controlled within the United States borders. The fed can select specifically from two methods depending on the condition of its economy. They can take an “contracting or expansionary policy, with the supply of money being influenced by these two specific methods.
Say there is an economic slowdown, the Federal Reserve frequently puts in place an expansionary policy for the market. The aim of this policy is to make more money available to businesses and banks to trigger growth and expansion. To achieve this it begins by decreasing its interest rates and expanding the monetary base.
Once trading increases, the economy recovers and starts begins to grow, the Federal Reserve will meet again to discuss whether to take contraction measures. Here the monetary base can become restricted pushing up interest rates. In turn this will increase the cost on lending money which causes the issue of less capital circulating in the system. Now the economy would be predicted to slow down, growth to stop and bring it back under control.
How it affects currency rates
By having control over interest rates and money supply, the Feds decisions due to their system have a big influence on either strengthening or weakening the value of the United States Dollar (USD). If more money is injected into banks and markets than required, values increase, creating a hoard of cheaper dollars into the open market, which will deflate their value. Likewise, if in an expansionary environment, if interest rates are lower, borrowing money becomes cheaper and the value of the currency will decline.
If you take the opposite scenario with this, if the Fed introduces a contraction monetary policy, there would be a decrease in the money supplied to the open market, making capital scarce. This Scarcity pumps up the value on the remaining funds which in turn increases the value of the USD. The same effect would happen by increasing interest rates. These higher rates of interest, make borrowing money more expensive, which decreases money availability. As the capital turns scarce, currency prices usually rise
So What does this mean for Traders?
To traders, knowledge is key! If a forex trader knows which policy cycle a central bank is going to take, you can hopefully now grasp that this is a fundamental piece of information to currency traders in whether to trade short or long. For more information on Central banking please read our other articles on this topic.