Central Banks, independent institutions utilized by countries globally, play a crucial role in overseeing their commercial banking sector, setting central bank interest rates, and fostering financial stability within their nations.
Central banks influence the financial market through several mechanisms:
- Open market operations (OMO): This involves the purchase and sale of government securities (bonds) in the open market to adjust the money supply in the banking system, with the goal of either expanding or contracting it.
- Central bank rate: Also known as the discount or federal funds rate, this rate is determined by the monetary policy committee to regulate economic activity. Despite appearing counterintuitive, adjusting this rate aids in managing inflation levels, aiming to keep them within a moderate range.
Moreover, central banks function as lenders of last resort. In situations where governments struggle to raise funds through bond auctions due to a modest debt-to-GDP ratio, the central bank can provide temporary liquidity assistance.
By serving as the lender of last resort, central banks bolster investor confidence by ensuring that governments will fulfill their debt obligations, consequently reducing government borrowing costs.
There are 4 MAJOR CENTRAL BANKS such as:
Federal Reserve Bank (United States)
European Central Bank (European Union)
Bank of England
Bank of Japan
Central banks have a mandate to serve the public interest, with responsibilities differing between countries. Key duties include:
1) Maintaining price stability by managing inflation.
2) Ensuring stability in the financial system through stress testing of commercial banks.
3) Supporting balanced and sustainable economic growth through monetary policy interventions.
4) Regulating and supervising financial institutions in the public interest.
5) Addressing unemployment as part of their broader goals, as observed with the Federal Reserve.
Forex traders closely analyze the language used by the central bank chairman to gauge potential interest rate adjustments. If the language hints at rate increases or decreases, it’s labeled as Hawkish or Dovish respectively. This subtle guidance, known as “forward guidance,” can significantly influence the forex market.
Traders expecting an interest rate hike may go long on that currency, while those anticipating a dovish stance may short the currency.
Changes in central bank interest rates provide trading opportunities based on interest rate differentials between currencies through carry trades. Carry traders aim to earn overnight interest by trading a high-yielding currency against a low-yielding one.
Source: https://www.dailyfx.com