Forex Basics | Fundamental Analysis

Role of Central Banks in the Forex Market

Central banks are the apex banks of their respective countries. The function of central banks is crucial to the sustenance of the nation’s economy. In line with this, the role of central banks in the forex market cannot be underplayed. Examples of central banks are the Reserve Bank of Australia, Bank of England, and the Bank of Japan.

What are Central Banks?

A central bank is a national bank that provides financial and banking services for its country’s government and commercial banking system. It also implements the government’s monetary policy and issuing currency.

Its goals are to stabilize the nation’s currency, keep unemployment low, and prevent inflation. Central banks are usually given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Functions of Central Banks

The following are the functions of central banks:

  • Issue of currency: Central banks are responsible for the issue of the nation’s currency. This is to secure control over the volume of currency and credit. The central bank acts as the controller of credit and money supply.
  • Banker to the government: The central bank acts as banker to the state and federal governments. The central bank is in charge of the banking activities of the government.
  • Lender of last resort: The central bank serves as a source of relief for commercial banks in times of financial crisis. This prevents the collapse of the financial structure of the nation.
  • Exchange control: The central bank regulates and controls the value of the nation’s currency internationally.
  • Banker’s bank and supervisor: The central bank acts as a supervisor, monitoring and regulating the activities of commercial banks.
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Other functions include:

  • Clearing house.
  • Collection and publication of data.
  • Custodian of foreign exchange or balances.

Role of Central Banks in the Forex Market

Central banks are responsible for the maintenance of a inflation. The aim is to enhance economic growth, while encouraging stability in the financial system.

Central banks intervene in the financial market through:

  • Open market operations: Open market operations refers to the process whereby governments buy and sell government securities in the open market. This is done to either increase or decrease the amount of money in the banking system.
  • The central bank rate: The central bank rate, also referred to as the interest rate. The monetary policy committee sets it with the intention of increasing or decreasing economic activity.

Hawkish vs Dovish

The position of the central bank on interest rate can be described as either hawkish or dovish.

When described as hawkish, the central bank hikes the interest rate to slow down economic growth and prevent excessive inflation. This results in an increase in the value of the nation’s currency.

When dovish, the central banks decreases the interest rate to accelerate economic growth and reduce deflation. The net effect is the reduction in the value of the nation’s currency.

In conclusion, central banks play crucial roles that cannot be undermined in the forex market. Therefore, it is advisable to keep an eye on them.

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