Forex Fundamentals: Interest Rates and Central Banks


At a time when interest rates across the developed economies of the world are at record lows, Interest rates is a fundamental economic indicator that cannot be ignored. No wonder, why speeches from Central Banks and monetary policy minutes are so eagerly watched every month. On average, around the release of this news, which also includes interest rate decisions, the respective currencies tend to be very volatile and the price action leading into a few hours after the release usually tend to change trend or continue the prevailing trend.

Understanding Interest Rates

The concept of a stronger currency attracting higher interest rate in comparison to other currencies forms the basis of the interest rate parity. Investors tend to seek high yielding currencies, or in other words, currencies whose interest rates are higher without getting too risky. This concept though has its exceptions. Take the example of emerging markets, where in the respective central banks tend to increase interest rates in order to attract foreign capital and thus spruce up demand for their respective currencies.

Central Banks use interest rates not just to control the strength of their respective currencies but also to boost their respective economies as well as control inflation. The general premise being that when interest rates are hiked, the cost of borrowing increases, ranging from mortgages to credit card borrowing which indirectly affects businesses and the end consumer. Likewise, when interest rates are slashed, it is used to encourage lending or borrowing in the markets to boost a sloppy economy.

Interest rates are used not just for the above mentioned reasons but also affect other markets such as bonds. Because bonds are bought by investors, the interest rates play a critical role. Higher the interest rates, better the demand for the bonds, pushing their face value higher.

Introduction of Forward Guidance

A new jargon that has been making rounds in regards to central bank’s interest rate decisions in recent times has been ‘Forward Guidance

Forward guidance is simply forward looking statements and the likely criterion for a shift in central bank’s policies. For example, the US Federal Reserve and the UK’s Bank of England has engaged in forward guidance where in a review of future interest rates are pegged to changes in the unemployment rate conditions. What this tells us, is that, in the above scenario, should there be a change (improvement) in the unemployment rates, the central bank would be looking to reviewing its interest rate decision (which could result either in a rate hike or a further cut). Besides, unemployment rates, forward guidance can also be considered based on other factors such as inflation, currency’s appreciation or depreciation, GDP growth and so on.

Why should you pay attention to interest rate decisions

It is essential for traders, regardless of whether they trade purely off technical analysis is to keep an eye out on the central bank speeches, which provides insights into the monetary policies and the underlying conditions which the central banks are monitoring. In recent times, especially in the case of the US Federal Reserve, markets have been paying a lot of attention to the ‘tapering’ of their Quantitative Easing. Therefore it is essential that traders should take into account the central banks’ statements before taking any trading decisions.