What is a central bank?
It’s worth starting with a small definition. Central bank is a sovereign national bank that operates independent of the government and influences the monetary policy, also acting like bank for the other banks of the nation.
The main objective of the central bank is to maintain price stability by controlling inflation and creating a stable economic environment for the country.
The central bank has one important characteristic: it is the only financial institution with the authorization to print hard currency. When printing money, the central bank has the ability to control the supply of money, that is, the total amount of money available in the economy. Using this capacity, the central bank regulates the level of inflation and the economic environment.
Let’s talk about the monetary policy used by central banks to control inflation.
To control the level of inflation, banks can adopt one of two types of monetary policy: accommodative or restrictive.
- Monetary policy accommodative / stimulatory / expansionist
If GDP growth is low, the central bank increases the money supply in the country and lowers the interest rate, aiming for economic growth and lower inflation. Business investments and consumer spending increase due to facilitated credit. Thus, in implementing such a policy, the bank creates conditions for economic growth, but affects the national currency.
Due to low interest rates, foreign investors will not have much interest in maintaining financial and capital assets in the country. In the same way, national investors will seek more attractive rates of return abroad. The fall in investments will lead to the fall in demand for the national currency, which will lose value against foreign currencies.
Concluding the accommodative monetary policy issue, one can say that when the central bank implements such a policy, this leads to the growth of the national economy, but has detrimental impact on the national currency.
- Restrictive / conservative / contractionary monetary policy
When the total amount of money in the economy gets huge, the central bank raises the interest rate to reduce the supply of money and decrease inflation. The high interest rate implies limiting the ability of companies and households to borrow, leaving national consumers at a disadvantage. However, by raising interest rates, the central bank creates conditions for investment: foreign investors tend to hold more national assets and thus improve the balance in the country’s capital account. Similarly, domestic investors will invest in their own country. The high level of investment will lead to the rise of the national currency, causing its exchange rate to rise.
To conclude, the implementation of a restrictive policy affects companies and families in the country due to high interest rates and the lack of opportunities to borrow money, while strengthening the national currency.
Conclusion: Why should traders follow central bank policy?
Going back to the main issue of this article, let’s summarize why it is so important for traders to take central bank policy into account.
To simplify the explanation, let us consider an example. When a central bank has lower interest rates and keeps them that way for a long time, traders can seek a central bank with the opposite policy: to raise interest rates. Traders keep money in the second central bank’s currency – which has higher interest rates – to get a higher return, or borrow money from the first bank with lower interest rates, and then use that money to finance investments in the other coin.
Another important fact is that the currency of the country whose central bank implements tight monetary policy is more stable. In addition, the economy of the same country is healthier than that of the country with accommodative monetary policy.
Consequently, the currency with the highest interest rate of the central bank will be valued against the currency whose central bank has the lowest interest rate.