Central banking policies and strategies forex traders should know

  • By Luke Andresen

  • July 3, 2018
  • 2:04 am BST

Many countries around the world make use of central banks to assist in commercial banking currency and interest rate management. Over the past 1,000 years, since the first physical money was issued in Asia, central banks have been working closely to create these management systems used by banks and traders globally today. The current system is highly dependent on modern technology to protect markets and trader investments. The most popular of these central banks include the United States Federal Reserve bank, commonly known as Fed. There is also the European Central Bank and Bank of England, the Reserve Bank of Australia and the Bank of Canada, which, all together, form the most popular central banks around the world used in forex trading markets.

United States Federal Reserve

The first central bank in the US was developed around the eighteenth century during the Revolutionary War of 1775. Congress at the time were looking to develop a national currency for credit funding, of which the continental value would rely on future taxes of an independent nation. However, the printing of counterfeit money reduced the overall continental value and caused the downfall of the currency. After meetings and planning to resolve this issue, the first Bank of the United States was established in 1791. The Fed was later developed in 1913 to protect the financial situation of the United States Central Bank through the use of monetary policies and bank regulations.

Bank regulations

When the New York Stock Exchange collapsed in 1907, a panic arose among all banks. As a result, the Fed regulations used today were set up to avoid the panic caused by unstable and unsafe finances and savings. Because many investors wanted to withdraw their money, there was a significant loss in capital, which needed to be resolved. This brought us the regulations that are currently in place to ensure this situation never occurs again. If problems should arise with a local bank, the United States Federal Reserve can loan capital at a lowered rate to allow banks to continue operating as per usual.

Monetary policies

Another example of the contingency plans used by the Fed is the implementation of monetary policies. These policies allow the Fed to control and protect money in the United States and consist of two main methods: a contracting policy and an expansionary policy. An expansionary policy would be used by the Fed if there were a delay in the economy, which will make more money available to businesses for larger financial expansion. Interest rates are reduced while the monetary foundation is increased.

Once this policy has helped the economy recover, the Federal Reserve will consider putting contraction measures in place. This involves increasing interest rates again and reducing the monetary base to allow the economy to normalize once more.

The effect on currency rates

Because the Federal Reserve has this level of control on interest rates and the distribution of money, they influence the value of the US dollar (USD) significantly. The value can easily decline if more money is distributed to banks and markets than necessary, or if interest rates are lowered in an expansionary situation and it becomes easier to borrow money. Alternatively, in a contraction situation, a reduction in the amount of money supplied would make capital scarce, causing the little remaining funds to see an increase in value and subsequently an increase in the value of the USD. Higher interest rates on money loans would have a similar effect, making money less available and thus increasing the value of the currency.

This knowledge and understanding forms part of essential forex advice for traders to heed when making decisions. By knowing which cycle a central bank is in, you can trade accordingly and stay one step ahead of the game.