/ How do central banks influence the Forex market?

Using different methods of operation, announcements and monetary policy, central banks influence currency trends and global economic activity. As a result, their actions are closely watched by economic players operating internationally and exposed to currency fluctuations. So what actions can central banks take to influence the foreign exchange market and thereby fulfil their monetary regulation mission. Read on to find out!

What is a central bank?

Central banks are government-owned, independent banking institutions that act as ‘banks of banks’. There are national central banks, such as the Swiss National Bank (SNB) or the Bank of France (BDF), as well as transnational central banks that cover the entire currency area, such as the US Federal Reserve (FED) or the European Central Bank (ECB). National central banks are owned by the states to which they belong (the latter are their shareholders), while transnational institutions are owned by the various central banks of the currency areas they govern. For example, the ECB is owned by the central banks of 19 euro area countries.

Be that as it may, central banks are the most important institutions in a country's economic system, as they manage a number of levers to maintain the banking and monetary stability of a country or its respective currency area. Interest rates, inflation, exchange rates and many other parameters that economic players pay attention to fluctuate depending on the decisions of central banks.

What is the purpose of central banks?

Central banks have several specific objectives, for example, they maintain price stability in their economic zone. Generally, they aim to maintain a fairly positive inflation rate (around 2%) and avoid any situation of deflation in order to promote economic growth and the stability of their currency. Another mission of central banks is to create the currency in circulation. It is these institutions that mint the banknotes and coins that we use every day.

Here too, central banks play an important regulatory role because the amount of money in circulation depends on their monetary policy. They can therefore decide at any time to issue more money or, conversely, to withdraw it in order to change the value. In the case of the world's largest central banks, these decisions affect the international market.
In addition, it is the central banks that manage the foreign exchange reserves of the respective currency area or country.

Whether it is the quantity of gold or foreign currencies, central banking institutions buy, sell or exchange them according to their needs, always endeavouring to maintain a stable exchange rate for their own currencies. Finally, central banks also perform a lending function for commercial banks, in particular by setting key rates at which the latter must borrow from them.

Which central banks are the most influential?

Although there are many central banks in the world, they do not all have the same power to influence the foreign exchange market. The larger the central bank's activities and the more important the currency it manages is to world trade, the more influence the bank has. The most important central banks in the world are:

• US Federal Reserve (Fed): Issues the United States dollar (USD) and manages the monetary policy of the United States;
• European Central Bank (ECB): Issues the euro (EUR), the single currency used by 19 European countries and central to trade in the Old Continent, and manages the overall monetary policy of the European Union (EU);
• Bank of Japan (BoJ): Issues the yen (JPY) and manages monetary policy for Japan, the world's third largest economy;
• Bank of England (BoE): Issues the pound sterling (GBP) and manages the monetary policy of the United Kingdom, the 5th largest economy in the world;
• Swiss National Bank (SNB): Creates and issues the Swiss Franc (CHF), a currency seen by many investors as a store of value in times of crisis, and manages the monetary policy of the Swiss Confederation.

How do central banks directly influence the foreign exchange market?

In order to fulfil their various tasks, central banks have a number of tools at their disposal that have a significant impact on the foreign exchange market. First of all, they can change their key rates - the interest rates at which commercial banks borrow funds from them. Banks then pass these rates on to their customers, who in turn adjust the cost of their loans. For example, a high key rate can stimulate economic growth and limit deflation, which is an increase in the cost of money.

Central banks also influence the foreign exchange market when they issue, withdraw or exchange currency quickly and in bulk. If a central bank withdraws large amounts of money from circulation, currency becomes scarce and its price rises. Conversely, if it starts printing money and floods the market with liquidity, its currency will de facto fall in value.
Further, it all depends on the specific monetary policy of the government associated with the central bank: some countries with a strong export orientation keep their currency relatively low (through the actions of their central bank) to stimulate orders from other countries.

Finally, central bank announcements also have a strong impact. Economic players and investors linked to the foreign exchange market scrutinise their announcements to anticipate changes in their currencies. In fact, a simple announcement can make many investors change their position in the market.

Conclusion

The mission of central banks is to maintain price stability, manage the money supply and ensure the stability of the financial system. By keeping an eye on the activities of central banks, traders can better predict market movements and make more informed decisions. Regardless of your level of trading experience, it is important to consider the actions and statements of central banks, as they can have a significant impact on your trading strategy and results.

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