Interest Rates
Interest rates are the crucial factor impacting the forex market. A central bank determines the main interest rates on its currency. The rates are tailored in order to provide trade incentives and to control inflation. Lower interest rates serve to boost economic expansion, owing to less costly credit. In the event of higher interest rates, economic expansion would be slowed down, as money “costs” would soar.
At this point it will be useful to discuss some of the main characteristics of central banks. These institutions are provided with access to enormous capital reserves and they target specific economic goals. For most central banks the latter are sustainable growth with low inflation.
Central banks carry out the regulation of money supply and of interest rates. They establish overnight lending rates so as to affect interest rates paid on their domestic currencies. In their effort to increase or decrease the money supply in an economy, central banks purchase and sell government securities. Sometimes they buy and sell their domestic currencies on the open market, aiming to impact exchange rates. The latter action in forex markets is known as an intervention.
The Open Market Committee of the Federal Reserve(FOMC) is the body which determines US overnight funds rates. As the Fed increases interest rates, dollar denominated assets offer larger yields, which is auspicious for attracting investors. With the reduction in interest rate, dollar denominated assets depreciate as well, so the incentives for investors for investing in dollars shrink accordingly.
It should be pointed out, however, that not only the rates themselves are of importance. Another factor of great significance is the language in which the statement accompanying the central bank decision is couched. In reality, it frequently happens that by the time the decision is announced, it has already affected the market and has been factored in; in cases when the decision matches the expectations, just minor fluctuations are observed. As for the statement accompanying it, it is scrutinized word-for-word for signsof what the central bank plans to do on its next meeting.
Inflation is a process scrutinized carefully by central banks. In case inflationary pressure settles in an economy, the central bank increases interest rates to control the situation. Curbing inflation is difficult after it has started, so the central bank meticulously stands on watch monitoring inflation expectations.
Higher interest rates make money borrowing more expensive, which discourages consumers from purchasing new properties, shopping by credit cards or taking out further loans. High borrowing costs are a deterrent to corporate expansion as the prevalent part of business is fulfilled on credit. High borrowing costs result in slowing down of the economy to reach a point where a central bank has to start lowering interest rates again, in an effort to boost economic growth and expansion. That is a cycle which goes on. The frail balance that each central banks pursuits is stable growth along with a low inflation level.
The benefit of increased interest rates for a nation is the corresponding increase in investors’ attention and willingness to invest in it. That is only logical since investors are after the highest possible returns. If a country’s interest rates are increased, that entails an increase in returns for the investors in that country. As investors place their investments in countries with higher interest rates, that stems the enhanced demand for the specific currency. A good state of a country’s stock exchange and high interest rates makes foreign investors strongly tempted into investing their capitals in that country. The result is increased demand for the country’s currency, which in turn results in its appreciation.
Interest rateshave the power to strongly affect capital flows in the specific country. Capital flows are money amounts received from abroad in the form of investments into the specific country’s market. Those amounts can significantly impact the exchange rate of the nation’s currency. With positive capital flows, it is clear that there is demand for that currency. Conversely, with negative capital flows, demand lags behind supply.
Central banks’ discussions regarding potential interest rate changes are followed with great attention, and they directly influence the movement of related currency pairs. Thus, any new announcement regarding interest rate changes is capable of altering trends for currencies. Central banks hold regular meetings with a frequency of every 4 to 6 weeks depending on each bank’s needs.
