Interest rates decisions are one of the most important economic events in the Forex industry. It can change the fate of a currency or a pair with the decision itself but also with the monetary policy a central bank is adopting.
What are interest rates
Interest rates are the amount of interest in a proportion of the amount of money lent in a specific period of time. In forex, interest rates are more related to central banks, and it responds to the level of interest central bankers charge regular lender institutions for the money they give them.
It sets the cost of the currency from the very base of the economy and confirms the minimums a bank can charge to its customers.
Interest rates are a cornerstone tool of monetary policies that central banks use to influence investment levels, consumer spending, inflation, and even unemployment.
Rates usually reflect the state of the economy of the country, or region in the case of the ECB. When an economy is healthy, central banks tend to maintain high interest rates while they cut rates and keep it low when the economy is having problems.
Reasons for changes in interest rates
While central banks are independent organisms focused on the stability of their currency and separated from political affiliations, its role can be bent in case of necessity.
Note that the notion os price stability can motivate movements beyond price stability and even surpassing frontiers such as the one the former Federal Reserve Chairman Ben Bernanke did during the darkest hours of the great depression.
After a question from a policymaker complaining Fed’s action in other countries and in partnership with other central banks, Bernake said that global economic problems were also a risk for the United States. So, the Fed’s measures to support other economies were, in fact, for the interest of the United States.
However, what are those reasons central banks usually have to make changes in their interest rate? Let’s see.
Economy performance: Usually, a healthy economy will have higher interest rates as a buoyant consumer will buy more, pushing prices higher. So, central banks would increase the interest rate to manage demand and inflation from uncontrolled jumps.
On the other side, a weak economy will need more money in the streets to motivate consumers and production. So, central bankers cut interest rates to make their currency cheaper, so everybody will have more access to money, and the domestic demand will rise. It will also fuel investments and inflation to higher levels.
Inflationary risks: As mentioned before, high inflation is bad, but deflation is ugly and even more dangerous for countries. So, central banks raise or cut rates to control inflation. Usually, they want it to be close to their 2.0% target.
Political short-term gain: Although it is unusual, some politics could push central bankers to make changes to drive the economy to the upside. It would be dangerous as it could also affect inflation and create bubbles. It can be used to transform the perception of a politician too, as a bad economy would make a president or prime minister look bad.
Forex interest rates and how to trading
Interest rate decisions are the blood in Forex, and it absolutely affects currencies and pairs.
In Forex, usually, the currency with the higher interest rate tends to be stronger than its counterpart with a lower interest rate.
Let’s take the EUR/USD as a sample. If America’s central bank has a funds rate of 2.0%, while the ECB has 1.0%, people will be more eager to buy dollars than euros, sending the EUR/USD down.
Besides, the more significant the change is after a rate decision, the more violent the reaction will be. Of course, note that sometimes the market prices in economic events as an attempt to anticipate developments and position better. So, you are not going to see the expected movement.
It also responds to the motto: buy the rumor, sell the fact. An art.
Most important central banks and impact in currencies
Federal Reserve and the USD
The Federal Reserve is the most important central bank in the world. It controls monetary policy and promotes the United States economy. Fed’s decisory board is the FOMC; it has meetings almost every month with some press conferences after the rate decision announcement. An optimistic Fed, and/or rate increases will fuel the dollar, while a pessimistic bank or cut in rates will push the greenback down.
Bank of England and the GBP
The Bank of England, also known as BoE, is the body which decides the monetary policy and interest rates in England. A hawkish BoE about economy and increases in interest rates is seen as positive for the British Pound while a dovish BoE is painful for the GBP.
When inflation rose above 3.0%, the BoE usually offer a press conference. It also happens after certain monetary policy meetings.
European Central Bank and the Euro
The ECB has specific paraphernalia at its monetary policy decisions. It always releases rate decisions in a brief press note, then the president of the European Central Bank offers a press conference where he, or she, reads a statement and answers questions.
A positive outlook about the economy in the eurozone, and/or interest rate increases will push the euro up; while a dovish or any rate cut will push the EUR down.
Bank of Japan and the JPY
The Bank of Japan, BoJ, sets the interest rate in Japan. Although it always has a date to be presented, they never say the release hour as a measure to control impact in the market and avoid high volatility hours. A hawkish BoJ will push the Japanese Yen higher, while pessimistic about the future of the economy Bank of Japan will drive the JPY down.