The Role of Central Banks in FX Markets

Central banks influence currency values and global markets through interest rate changes, monetary policy tools, and direct interventions. Their decisions impact businesses, investors, and economies worldwide. Here's what you need to know:

• Interest Rates: Raising rates strengthens a currency; lowering rates weakens it.
• Monetary Policy: Tools like quantitative easing (QE) and tightening (QT) affect liquidity and exchange rates.
• Direct Interventions: Actions like buying or selling currencies stabilize or adjust exchange rates.
• Communication: Clear messaging helps guide market expectations and avoid disruptions.

Quick Facts:

• The Federal Reserve's rate hikes (2022–2023) boosted the U.S. dollar to a 20-year high.
• Central banks like the Swiss National Bank and Bank of Japan use interventions to manage currency volatility.
• Global forex trading hit $7.5 trillion daily in 2022.

Central banks balance domestic goals, like inflation control, with global economic impacts. For businesses, managing currency risk is critical to navigating volatile markets.

How do monetary policies affect the forex market?

How Monetary Policy Affects Currency Markets

Monetary policy tools play a major role in shaping foreign exchange (FX) markets. In fact, daily forex trading reached a staggering $7.5 trillion in 2022.

Effects of Interest Rate Changes

Interest rates are a central bank's go-to tool for influencing currency values. When rates are raised, it often strengthens the local currency by attracting foreign investments. For example, during the COVID-19 pandemic, the Federal Reserve slashed rates to near zero. Later, by July 2023, it increased the target range to 5.25–5.50%, pushing the U.S. Dollar Index to its highest level in 20 years.

Bond Buying and Selling Programs

Quantitative easing (QE) and quantitative tightening (QT) programs impact currencies by altering market liquidity and interest rates. Studies show that QE measures announced by central banks like the European Central Bank or the Federal Reserve can cause a sustained exchange rate drop of around 7%. For instance, the Federal Reserve's balance sheet expansion to nearly $9 trillion and the Eurosystem's €1 trillion bond reduction, which raised risk-free rates by about 35 basis points, highlight how these programs directly influence currency values. Beyond these actions, central banks use carefully crafted messaging to guide market expectations.

Market Communication Strategies

Clear communication is critical in shaping how markets respond. Former Fed Chairman Ben Bernanke famously said, "Monetary policy is 98% talk and 2% action". Forward guidance is key to avoiding unexpected disruptions. In September 2020, the Federal Reserve set specific conditions for future rate changes:

"The Fed said it would leave interest rates near zero until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and was on track to moderately exceed 2 percent for some time"

Even small changes in central bank phrasing can lead to major shifts in market behavior.

Direct Currency Market Actions

Central banks don't just rely on monetary policies - they also step into foreign exchange (FX) markets to influence currency values directly.

Methods of Currency Control

To manage their currency's value, central banks use two main techniques: sterilized and unsterilized interventions.

• Sterilized interventions: Central banks balance out the effects on the monetary base by buying or selling domestic government securities alongside their currency market actions. This approach avoids altering the domestic money supply.
• Unsterilized interventions: These directly impact the money supply by skipping any offsetting measures. As a result, they often cause quicker changes in exchange rates. For instance, a $1 billion currency purchase might weaken the domestic currency by 1%. However, the effectiveness of these actions often hinges on whether markets see them as hints of future policy moves.

Types of Market Intervention

Central banks decide between interventions that either maintain or change the domestic money supply. Here's a quick breakdown:

These methods have been used in several high-profile cases, as outlined below.

Major Bank Intervention Examples

• Bank of Japan (2022): Faced with a weakening yen, the Bank of Japan stepped in twice. In September, it spent nearly $20 billion to counter the yen's drop to 145.90 per USD. The next month, it carried out its largest-ever yen purchase.
• Swiss National Bank (2015): In January, the Swiss National Bank unexpectedly removed the franc's 1.20 peg to the euro and slashed its key interest rate to –0.75%. This decision sent shockwaves through global markets, showcasing how abrupt policy changes can dramatically affect currency values.
• Mexico's Central Bank (2008): In October, Mexico's central bank sold $3 billion to prop up the peso. Despite this effort, the peso continued to slide over the following year, highlighting the challenges of such interventions in emerging markets.

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Managing Economic Goals and Exchange Rates

Central banks play a dual role: maintaining currency stability and achieving broader economic objectives. These efforts impact both local economies and global markets. While direct interventions address short-term currency fluctuations, broader strategies focus on long-term economic health.

Price Stability and Exchange Rates

A key goal for central banks, like the Federal Reserve, is maintaining price stability - often targeting a 2% inflation rate. When inflation exceeds this target, central banks typically respond by raising interest rates, which can strengthen the domestic currency. For example, historical rate adjustments show how this tool helps balance inflation control with economic support. These policies are critical for ensuring stable economic conditions.

Inflation targets also influence the choice of exchange rate systems, linking price stability to currency management.

Currency System Types

The type of exchange rate system determines how central banks manage their currencies:

A notable example of fixed rate challenges occurred in 2018 when Iran set a fixed rate of 42,000 rials to the dollar after an 8% single-day currency collapse.

Local vs. International Priorities

Central banks face the challenge of balancing domestic needs with global impacts. This is particularly complex for the U.S. dollar, which is used in about 60% of international financial transactions. Decisions by the Federal Reserve often have far-reaching effects on global markets.

"The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy 'so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.'"

The Fed's actions highlight how central banks prioritize domestic goals while considering global consequences. For instance, during the 2007-2009 financial crisis, the Fed not only cut interest rates but also purchased approximately $3.7 trillion in assets. This demonstrates how addressing domestic challenges can sometimes require large-scale international market intervention.

Effects on Market Participants

Central bank decisions send ripples through currency markets, directly affecting businesses and investors involved in international transactions. Recent data highlights the scale of the challenge: 72% of small and medium-sized enterprises (SMEs) report losses from currency fluctuations, and 57% of CFOs say unhedged foreign exchange (FX) risk has reduced earnings.

Business Currency Protection

To navigate currency volatility, businesses need solid strategies. For example, the Federal Reserve's rapid rate hikes from 2022 to 2023 - raising rates from near-zero to between 5.25% and 5.50% - show how quickly currency values can shift. Even as of January 2025, with rates adjusted to 4.25%–4.50%, managing currency risk remains a pressing issue.

Reading Central Bank Messages

Staying ahead of central bank announcements is key to managing currency risk. For instance, the Federal Reserve's unexpected 50 basis point rate cut in September 2024 caused a sharp EUR/USD shift to 1.1200 before reversing due to later economic data.

"Central banks are the most influential financial institutions, as they hold power to drive money creation, money supply and even currency value to a large extent. It is prudent for businesses, no matter small, medium or large, to keep up to date with the central bank's measures and their impact on interest rates, currency value and many more." - Matthew Ryan, Ebury's Global Head of Market Strategy

Time-Based Currency Planning

Sudden policy changes can trigger immediate market reactions, making careful planning essential for businesses handling international transactions. Here's how companies can prepare:

• Short-term Protection: Keep an eye on upcoming central bank announcements and use flexible hedging strategies.
• Medium-term Planning: Monitor economic indicators that influence central bank decisions.
• Long-term Strategy: Build a robust risk management framework, especially since 90% of large firms already have formal FX policies.

Treasury management software and specialized financial services can help businesses stay on top of exposure and implement effective hedging strategies. These tools are especially useful during volatile periods, such as major central bank announcements.

Conclusion

Main Points

Central banks influence foreign exchange (FX) markets through various tools, such as:

For instance, the HKMA ensures the Hong Kong dollar's fixed exchange rate by fully backing it with U.S. dollar reserves.

Future Central Bank Trends

Looking ahead, central bank strategies are shifting to adapt to evolving economic conditions. For context, global trade shrank from 5–6% growth to -2% between 2017 and 2019.

• Increased Global Coordination: Central banks are working more closely together to ensure currency stability.
• Improved Communication: Clear and transparent forward guidance is becoming essential for maintaining market confidence.

According to a Nordea survey, 43% of Nordic corporate treasuries expect high FX market volatility in the coming years.

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• The Future of Digital Currencies in FX Markets
• The Impact of Interest Rates on FX Markets