The era of the Central Banks began in 1913 with the founding of the U.S. Federal Reserve. There were central banks before that exercised immense power-particularly the Bank of England-but the economic influence of the USA and the Fed, was like nothing before. Moreover, the U.S. Fed-a private institution-was given a more independent role than other banks, as well as a dual mandate. Today, the U.S. Fed continues to be in the driver’s seat of the global economy with an unparalleled influence on the valuations of currencies.
Central banks drive market action. While the fiscal and trade policies of governments have enormous effects on markets, it’s the monetary policies of central banks that are the main drivers in currency and bond valuations. They are usually the issuers of fiat currencies as well.
The main central banks and the currencies related to them are: US Federal Reserve Bank (USD),European Central Bank (EUR), Bank of England (GBP), Bank of Japan (JPY), Swiss National Bank (CHF), Bank of Canada (CAD), Reserve Bank of Australia (AUD), Reserve Bank of New Zealand (NZD), and the People’s Bank of China (CNY). China’s currency is not free floating, though it is assumed that it will be in the not too distant future. Russia, Brazil and India’s central banks are also growing in importance in line with their increased role in the global economy. Here is a brief synopsis:
What Central banks do:
Interest Rates. Central banks generally act as the supplier of capital and liquidity to a nation or regions’ banks in the case of the ECB. This is done by loaning money to member banks for short periods. Central Banks charge interest on these loans. The interest rate charged to the banks-whom subsequently, lend out funds to businesses and consumers at a higher rate-is the main tool central banks use to control and influence the cost of money, and hence the value of currencies. At present, most of the major central banks have set rates lower than 1%, and some near 0%, to stimulate consumer spending and economic growth. When the rates of inflation change (2-2.5% for most economies), central banks restrict the supply of money by raising interest rates they charge member banks. This makes consumer loans more expensive and restricts the demand for that particular currency.
Reserve requirements. Another tool that central banks can utilize is changing the reserve requirement. This is the amount of capital that banks must keep in reserve to cover loans. Central banks can alter this requirement to affect currency valuations, lowering the requirement when it wants to stimulate demand, or restricting when it wants to tighten. Central banks can also require that currencies be backed by other instruments such as gold. Although the USD-the world’s reserve currency-went off the gold standard, central banks have been net buyers of gold in recent years. This many reflect a desire to stabilize currency values, or in anticipation of future inflationary trends. In any case, central banks use a myriad of strategies to meet their obligations.
Market intervention. Central banks have several tools they can deploy in the marketplace to affect a currency’s value. They can buy or sell currency reserves, including their holdings of foreign currencies, as well as buy and sell bonds. At the current time for example, the U.S. Fed has been buying bonds as part of a long term Quantitative Easing program, which is direct intervention in the markets. The Bank of Japan has also been very aggressive with their monetary policy, though the effects have been muted and deflationary patterns still exist.
Why central banks?
Inflation. The primary job of central banks is price stability and fighting inflation. Current Federal Reserve Chairman Bernanke has stated that preventing deflation-such as the type that occurred in the 1930s during the Great Depression-is another priority. History suggests that central banks have not done a great job with inflation, often letting it take hold for long periods before they are able to address it. Some economists postulate that fiat or paper currencies not backed by gold are impossible to control, and the tendencies of central banks is either to be too loose with monetary policy, or too tight, with more emphasis on the former.
Unemployment. While fighting unemployment is not the primary role of central banks, it is understood that this is one of their aims. For the U.S. Federal Reserve, it is part of their dual mandate along with price stability. This complicates the job of the Fed, as the measures used to fight inflation may be contradictory to easing unemployment.
How it affects trading:
Liquidity. The actions as well as the inactions of central banks affect market liquidity in several ways. First, any interventions in the market-even the most subtle shift of intentions-changes the dynamics of supply and demand, affecting the overall trends of markets. Market players-large banks, hedge funds, sovereign wealth funds, and other central banks-change their positions as a result of, or anticipation of central bank activity. Interest rate changes tend to have volcanic effects on markets, though speeches, testimonies and press conferences can also cause ‘earthquakes” as traders react to policies.
Volatility. Any measurement of volatility indicates that central bank actions or speeches by central banks heads, has profound effect on markets. Many traders will close their positions before central bank announcements or at least adjust their stops to accommodate the increased volatility that results. It is not uncommon for the EUR/USD for example, to whipsaw 100 or more pips whenever the ECB President or Fed Chairman speak.
Trends. The actions of central banks tend to outline or confirm trends. Central banks review substantial amounts of data before making decisions, cognizant of their effects and the time it takes for their policies to affect economies. Traders benefit by noting central bank actions and tracking any shifts in policies. A recent comment by a Federal Reserve member that Quantitative Easing might be pared down very soon, sent gold (XAU) down precipitously. Subsequent employment news caused the markets to pause on that assessment. Traders will watch for signs from the U.S. central bank, as well as others, that the loose money environment is not coming to end just yet.
There is some debate whether central banks have lost their ability to shape global economies. Case in point is Japan where the BoJ has had stimulus after stimulus for more than two decades. While this is normally inflationary, Japan has experienced deflation. The U.S. Federal Reserve has also tried inflating the U.S dollar, though the measurement of current inflation levels is subdued. There is also the question of whether the age of central banks is over. Many believe that the banks are creating bubbles, economic calamities, and future periods of hyper inflation and economic instability. This remains to be seen. Meanwhile, people are looking for alternatives from gold to virtual money not tied to central banks, like Bitcoin.