If you follow the financial markets, it’s possible that you have seen how much the markets react to news central banks. This is because traders in the market understand the large effect that central bank actions can have on assets and the wider economy. This article will explain the role of central banks in the financial markets and why you should pay close attention to their actions.
Most countries in the world have a central bank. The most influential central banks are the Federal Reserve, the People’s Bank of China, European Central Bank, Bank of England, Swiss National Bank, and Bank of Japan. These banks are independent from political interference. As a result, the officials are selected in an impartial way. In the past, central banks that have been influenced by politicians have sometimes made harmful decisions.
The first role of the central bank is to ensure the financial safety of a country’s banking system. They do this by being the main banking regulator in the country. One way they ensure safety of the system is by setting the minimum capital requirements for other banks. This means that the bank puts in place the minimum amount of money they must have in reserve in order to do business. This enables it to determine how a bank can lend money.
The second role of the central bank is to set the interest rates in a country. This decision is made by a committee of the bank’s leaders. In the United States, the decision is made by the Federal Open Market Commission (FOMC). The decision to raise or lower interest rates is significant because it plays an important role in the economy of a country, therefore affecting its currency’s value.
When there is a financial crisis, the central bank responds by lowering interest rates. A good example of this is what happened after the financial crisis of 2008/9. To spur growth, the bank lowered rates to almost zero. When interest rates are low, it spurs growth. This is because companies can borrow money cheaply to fund more growth. Equally, individuals can borrow to invest in the market or to buy other items like cars and real estate.
When the economy is doing well, the central bank might decide to raise interest rates. The reason for this is to prevent the economy from overheating. When it overheats, it exposes the market to risks in case of a sudden slowdown. A good way to explain this is to consider a car moving at 150 KMH that needs to stop suddenly. In such a situation, the car will likely cause an accident.
The third role of the central bank is to take control of inflation. Inflation is mostly caused by a reduction of the unemployment rate, affordable capital, and increased consumer confidence. The bank wants an economy that is fairly balanced. Very high inflation is undesirable because it makes things unaffordable. Very low inflation is also undesirable because it leads to lower profit margins for companies and then leads to high unemployment rate. Therefore, the central bank sets the target for inflation and then controls it with interest rates.
When you are currency trading online, you need to be well-informed about the decisions of the central bank. A good way to do this is to look at the economic calendar to know when key announcements will be made, and then interpret the information that is released so you can act on it. In addition to the calendar, you should follow the speeches of the central bank officials and the reports they release. You can then look at how this data affects the currencies you are interested in, and make trading decisions based on the market movements.