Forex: Interpreting Central Bank Interest Rates for Trading Success

To practice Forex trading with knowledge, it is necessary to leave nothing to chance. This advice applies to both the operational and strategic or analytical phases. In fact, it is in the analytical phase that most of one's intellectual and cognitive resources should be focused. The issue revolves around this simple concept: to be able to earn, it is necessary to intuit the direction in which prices will move, and to do so, it is necessary to analyze the current context. Clues about what will happen in the future are always in the "present". When talking about Forex, and therefore the currency market, this means studying the monetary context, that is, monitoring the actions of central banks. In this perspective, the decision on interest rates that the Fed, the ECB, and others regularly make assumes paramount importance. We discuss this in this article, offering an overview of the relationship between interest rates and Forex, and providing some advice for using interest rates in the analytical and strategic phase.

What are interest rates and what do they have to do with Forex

The expression "interest rate" simply means the cost of money, that is, the return that the central bank applies to national banks and commercial banks when transmitting money flows. With a rather predictable domino effect, these interests swell as they travel down the supply chain, until they reach the retail credit market. From the point of view of central banks, the decision on interest rates is a fundamental tool for correctly managing the monetary context, ensuring a correct monetary transmission, and above all avoiding or resolving distortions regarding prices. The main purpose of manipulating interest rates is, in essence, to maintain inflation around 2%. This, in reality, is an ideal target, which is often missed for a variety of reasons. However, there is no doubt: central banks are called upon to do everything, within the limits decided by their statutes, to (at the very least) tend towards this objective. In any case, we speak of interest rates in the plural, as this term also includes other types of interest such as that on deposits or concerning certain types of money flows. However, the manipulation of interest rates generates a whole series of effects that also have repercussions on the market, and in particular on Forex. In a nutshell, every action of central banks in this regard impacts the relationships between currencies. The reason, on a logical level, is quite evident: currencies behave like any asset. Therefore, they are subject to the law of supply and demand. Now, the manipulation of interest rates always generates more or less direct effects on the currency supply. Hence the consequences on "prices".

What happens if interest rates are raised

Let's now examine the two most significant and at the same time frequent cases. In particular, we are talking about decisions that cause an increase in interest rates. In simple terms, when rates are raised, the currency supply, i.e., the money supply concretely in circulation, is reduced. This leads, again by the law of supply and demand, to an increase in the "price". This translates, in turn, into greater strength of the currency in question compared to all others. Why should a central bank raise interest rates? Generally, central banks increase the cost of money when the need to reduce inflation emerges. By reducing the money supply, in fact, the currency is revalued not only externally but also internally. Generally, central banks that are called upon to manage hyperinflationary economies keep interest rates constantly above 3%.

What happens if interest rates are lowered.

The opposite is true if interest rates are lowered. In this case, the currency supply expands, and with it the money supply in circulation. If borrowing money is less expensive, the credit market is able to meet the needs of a greater number of individuals and economic actors. Again, by the law of supply and demand, it appears obvious how this dynamic causes a devaluation of the currency itself and therefore a loss of strength compared to other monetary currencies. Generally, central banks lower interest rates when inflation is too low. The devaluation, similarly to what happens in the case of an increase in rates, is not only external but also internal. Central banks that adopt this monetary policy generally keep rates constantly below 2%, and often approach zero. This is the case, for example, of the European Central Bank, whose interest rates have been at 0% for many years now.

Understanding the context

Obviously, it is not enough to know these simple dynamics to be able to correctly interpret the decisions of central banks regarding interest rates. There is much more material to consider if you intend to make the most of your analysis activities. Specifically, it is advisable to analyze the behavior of central banks also in light of all the other parameters that, from the outside, can affect the price. In short, it is necessary to contextualize. If, for example, an economy is experiencing a moment of difficulty, and inflation has been tending to decrease for a long time, it is absolutely predictable that central banks will adopt an expansive monetary policy that provides for permanently very low interest rates. In this context, any decision on interest rates is rather predictable, therefore already widely discounted by investors. It goes without saying that any communication in this regard will not have the desired or expected effect according to simple theory. Obviously, the same is true in reverse. Let's take the example of some emerging economies (India, Brazil, etc.). They suffer from very often high inflation, so even in this case, the monetary policy of the respective central banks is quite predictable, and not surprisingly provides for maintaining interest rates at levels certainly above 3%. Also in this case, communications from central banks in this regard struggle to have any effect on the market, precisely because any decision has already been discounted by investors as it is extremely predictable.