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The role and influence of central banks on the foreign exchange market

11 August 2020

Skyscraper of the European central Bank in Frankfurt

What role do they play? How do they affect exchange rates and What influence do they have on the forex market? Find out everything you need to know about central banks in just five minutes.

 

As the monetary authority of a country’s economy, central banks are responsible for regulating and monitoring the banking system of the country in question. They are in charge of formulating the country’s monetary policy and although they are politically independent, they have a statutory monopoly status in their country which gives them the power and responsibility to issue money. Described as the “lender of last resort” central banks are responsible for creating sufficient reserves and govern the banking industry by ensuring commercial banks are not facing a supply shortage, as was the case during the 2008 financial crisis.

Central banks typically intervene to prevent excessively large and rapid evolutions in the value of their currencies. This ensures that the latter are neither undervalued nor overvalued for an excessively long period.

Among the main methods of central bank intervention, one may include the issuing and withdrawal of liquidity in the domestic currency or a massive currency swap over a relatively short period of time. To increase a currency’s rate, central bank can lower the supply of their currency which will have the effect of increasing the demand of the currency. Conversely, by selling the domestic currency in exchange for other currencies, this increases the supply of a currency and causes its value to fall. Currency devaluation makes domestic goods cheaper than foreign goods which itself has both positive and negative effects on a country’s currency.


What role do central banks play?

Central banks perform three main functions:

1. Regulating the market

  • One of the primary functions of central banks is to regulate economic activity by setting interest rates, typically referred to as the key interest rate.
Key interest rate
Even though they do not directly control the foreign exchange market, central banks can directly influence inflation and exchange rates by raising or lowering the key interest rate. This is the instrument used to refinance banks with liquidity and it is the main indicator of the cost of credit within an economy. If the key rate is low, this indicates that the cost of credit is low, thereby promoting growth.

2. Managing foreign currency reserves

  • Another central bank function is the management of foreign exchange reserves.
  • Depending on their reserves, central banks may decide to buy foreign currency or sell the local currency in order to influence its value.
  • In this way, they try to control the price of their currency in order to avoid either under- or overvaluation.

3. Controlling the supply of money in circulation

  • A central bank may decide to issue or withdraw liquidity in the domestic currency to regulate the amount of money in circulation. 
  • All central banks play an essential role. However, the weight of the currency and the economy they represent gives some of them an international dimension.

Which central banks are the most important?

The most important central banks include the ECB European Central Bank, the Federal Reserve, the Bank of England, the Bank of Japan, the Swiss National Bank and finally the Bank of Canada. Because of their country and their currency’s weight in the world economy, the influence of these central banks goes beyond their country’s borders.

Foreign exchange market participants pay special attention to the announcements and interventions of these central banks, as their decisions affect the most traded currency pairs and the global economy at large.

 

1. The European Central Bank (ECB)

The European Central Bank ensures the smooth functioning of the economic and monetary union of all the countries having adopted the single currency.

  • It heads the European System of Central Banks (ESCB), which is composed of the central banks of the eurozone, as well as those of the countries that have not yet adopted the single currency within the bloc.
  • It acts to ensure price stability and the smooth operation of foreign exchange transactions and payment systems.
  • It sets interest rates for countries within the monetary union and lends to commercial banks according to the key interest rate in force, helping to regulate the money in circulation and keep inflation under control.
  • The ECB also authorises the issue of euro (EUR) banknotes by eurozone countries.
Did you know? 
The ECB is unique in that it is the only central bank in the world responsible for the monetary policy of 19 Euro area countries, despite the diversity of economic models within the eurozone. It is fully independent of the EU institutions.

 

2. The Federal Reserve (Fed)

  • Founded in 1913, the Fed is the guardian of the US economy and the world’s most influential central bank.
  • It oversees the supply of dollars (USD) in circulation and, due to its importance, international liquidity as well.
  • It sets interest rates through a committee called the Federal Open Market Committee, which meets eight times a year to make decisions on the US monetary policy and banking system.
Did you know? 
Unlike most central banks, the Fed operates under a decentralised structure. At the federal level, it is managed by its Board of Governors, while at regional level, there are 12 Federal Reserve Banks that operate as private entities.

 

3. The Bank of England (BoE)

  • The Bank of England has been an independent entity since 1997.
  • It is owned by the British state and is regulated by the UK Financial Service Authority (FSA).
  • It ensures price stability and sound banking and financial systems in the United Kingdom.
  • For more than 300 years, it has also issued pound sterling (GBP) banknotes and managed the supply of money in circulation.
Did you know? 
The United Kingdom was a member of the ERM (European Exchange Rate Mechanism), the predecessor of EMU (European Monetary Union), between 1990 and 1992. However, on 16 September 1992, also known as “Black Wednesday”, the country was forced out of the ERM. The Bank of England found itself unable to stop the devaluation of the pound sterling, while the introduction of the single currency required the stabilisation of European currencies around a specific rate. This foreshadowed the maintenance of the UK’s national currency.

 

4. The Bank of Japan (BoJ)

  • Founded in the 19th century with the creation of the yen (JPY), the Bank of Japan has been independent since 1998.
  • The Bank of Japan manages the issuance of banknotes and ensures the financial stability of the country.
  • Like other central banks around the world, it contributes to price stability and sets interest rates to ensure a relatively stable cost of credit and a liquid market
Did you know? 
In response to the bursting of the housing bubble and the ensuing financial crisis in the late 1990s, the Bank of Japan pioneered the adoption of certain monetary policies, which have since become more widespread:
• Zero interest rate policy to curb deflation (1999).
• Quantitative easing policy (2001).

 

5. The Swiss National Bank (SNB)

The Swiss National Bank (SNB) is the central bank of the Swiss Confederation. It establishes the country’s monetary policy and issues the national currency, the Swiss franc (CHF).

  • The SNB’s main function is to ensure price stability in the Swiss market.
  • It also issues Swiss franc banknotes and sets interest rates in order to moderate inflation.
  • The SNB manages the country’s foreign currency and gold reserves.

 

6. The Bank of Canada (BoC)

Bank of Canada (BoC) is Canada’s central bank and is responsible for the country’s monetary policy.

  • It sets the interest rates in force in the country and controls the money supply in circulation.
  • It also manages Canada’s foreign currency reserves and issues banknotes in the domestic currency, the Canadian dollar (CAD).
Did you know? 
The Bank of Canada is a member of the Four Nations Group, which is composed of five members: the US Federal Reserve, the Bank of England, the Reserve Bank of Australia and the Bank of Mexico. These institutions cooperate in research and innovation.

 

While all central banks play an essential role, some have a greater impact on the foreign exchange market, depending on the economy and the currency they represent.

They all share a common objective: to ensure price stability within a country or a monetary union. In order to achieve their goals, their methods of intervention vary.

Keeping a close watch on central bank announcements and interventions that generally highlight a country’s main economic indicators  helps us better understand developments in the foreign exchange market and anticipate potential currency fluctuations. Our annual FX calendar is ideal to help keep track of upcoming central bank meetings.

 

 

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